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, 2004

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: None | Name of each exchange on which registered: N/A
|------------------------- | ----------------------------------------------

Securities registered pursuant to Section 12(g) of the Act:
                  Common Stock,       $0.001 par value

(Title of class)

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 an accelerated filer (as
defined in Rule 12b-2 of the Act).
    Yes  
x    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,
2004 (which is the last business day of registrant's most recently completed
second fiscal quarter), as reported on the Nasdaq National Market was
approximately $628.8 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, 2005, the Registrant had 41,812,166 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 2004 ANNUAL REPORT ON FORM 10-K
                               TABLE OF CONTENTS



|Part I.    |                                                                                                              | Page
|---------- | ------------------------------------------------------------------------------------------------------------ | ----
|Item 1.    | Business                                                                                                     | 3   
|Item 2.    | Properties                                                                                                   | 18  
|Item 3.    | Legal Proceedings                                                                                            | 19  
|Item 4.    | Submission of Matters to a Vote of Security Holders                                                          | 19  
|Part II.   |                                                                                                              |     
|Item 5.    | Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities | 20  
|Item 6.    | Selected Consolidated Financial Data                                                                         | 21  
|Item 7.    | Management's Discussion and Analysis of Financial Condition and Results of Operations                        | 22  
|Item 7A.   | Quantitative and Qualitative Disclosures about Market Risk                                                   | 43  
|Item 8.    | Consolidated Financial Statements and Supplementary Data                                                     | 44  
|Item 9.    | Changes in and Disagreements with Accountants on Accounting and Financial Disclosure                         | 71  
|Item 9A.   | Controls and Procedures                                                                                      | 71  
|Item 9B.   | Other Information                                                                                            | 71  
|Part III.  |                                                                                                              |     
|Item 10.   | Directors and Executive Officers of the Registrant                                                           | 71  
|Item 11.   | Executive Compensation                                                                                       | 71  
|Item 12.   | Security Ownership of Certain Beneficial Owners and Management, and Related Stockholder Matters              | 71  
|Item 13.   | Certain Relationships and Related Transactions                                                               | 71  
|Item 14.   | Principal Accountant Fees and Services                                                                       | 71  
|Part IV.   |                                                                                                              |     
|Item 15.   | Exhibits and Financial Statement Schedules                                                                   | 72  
|Signatures |                                                                                                              | 74  

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 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; 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
"Management's Discussion and Analysis of Financial Condition and Results of
Operations - Factors Affecting Future Operating Results" section of this
Form 10-K.  The reader is cautioned 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

We are a global medical device company specializing in the design,
manufacture and marketing of medical devices to treat and restore spinal anatomy
using minimally invasive technology.  Our devices are used primarily by spine
specialists including orthopedic surgeons and neurosurgeons, interventional
radiologists, and interventional neuroradiologists who repair spinal fractures
caused by osteoporosis, trauma, cancer or benign lesions through performing
minimally invasive surgery known as kyphoplasty.  Our commercial products
consist of our KyphX® instruments, used to treat spine fractures
during kyphoplasty, including our proprietary KyphX balloon technology
and our proprietary brands of bone filler materials.  Surgeons use these
instruments to help repair spinal fractures during minimally invasive spine
surgeries.  Most alternative spine fracture treatments are either highly
invasive or are only pain management therapies.

We believe there are approximately 700,000 clinically-diagnosed spine
fractures in approximately 550,000 patients each year due to osteoporosis in the
United States and Europe.  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 spinal 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 the United States and Europe, 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 the United States and Europe 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.

As of December 31, 2004, we had trained more than 5,600 physicians in the
United States, Europe and Asia Pacific on the kyphoplasty technique, and these
physicians had used our instruments in over 110,000 spine surgeries.  To support
these physicians, we have built a large and growing worldwide direct sales
organization that numbered in excess of 350 professionals as of December 31,
2004.  Kyphoplasty treatment of spinal fractures results 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 anesthesia 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, kyphoplasty has been demonstrated
to have a low complication rate.

In May 2000, we commenced full commercial introduction of our KyphX
instruments in the United States. We devote significant resources to product
development, supporting our sales and marketing team, training and educating
physicians and supporting reimbursement and clinical activities related to our
products.

In February 2003, we acquired Sanatis GmbH, a privately-held developer and
manufacturer of orthopedic 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 for our first product
from the acquisition of Sanatis GmbH, our KyphOsTM calcium phosphate
cement, in December 2003, and we are now authorized to sell this material in
Europe.

We intend to pursue the research, development and commercialization of spine
products arising from this acquisition and from our license to a portfolio of
patents we acquired from Bonutti Research in August 2002, as well as other
product initiatives, to complement our existing KyphX instruments and to
leverage our experienced sales force and expertise in spinal fracture
treatments.  The full commercialization of products from these acquisitions will
require research, development, and regulatory approvals and/or clearances, and
may require clinical studies prior to market launch.  In addition, we may pursue
additional acquisitions, including acquisitions of non-spine 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.

Anatomy of the Spine

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.

Consequences of Spinal 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 spine fractures include trauma, cancerous and benign tumors and
infection.

Unrepaired spine 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

Market Opportunity for the Treatment of Spine Fractures

We believe that each year in the United States and Europe an estimated
700,000 clinically-diagnosed spinal fractures in 550,000 patients occur due to
osteoporosis as well as 150,000 fractures in 50,000 patients due to cancer.  In
addition, we believe that minimally invasive fixation techniques are appropriate
for as many as 100,000 vertebral body fractures annually that are caused by
trauma.  In the U.S. alone, we believe there are an additional 440,000
osteoporotic fractures per year that go undiagnosed.  The majority of the
diagnosed fractures are managed in the hospital or at home, predominantly with
conservative treatment options such as bed rest, pain medication and back
braces.  Approximately 150,000 people in the United States per year are
hospitalized due to pain associated with spine fractures caused by osteoporosis,
resulting in annual costs estimated to be in excess of $1.6 billion.  The number
of fractures caused by osteoporosis is increasing more rapidly than the aging of
the population, which has been assumed to be related to increasingly sedentary
lifestyles.

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.  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.

Alternative Means for the Treatment of Spine Fractures

When treating a patient with a spine fracture, an orthopedic 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 orthopedic surgical techniques to reduce and otherwise repair spine
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 spine
fractures, but instead prescribed therapies and treatments designed to simply
manage the pain.

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, 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 cancer-related fractures, and is used to
treat only a portion of the trauma-related fractures.

Pain Management Therapies

Due to the limitations of conventional orthopedic surgery for patients with
spine fractures, the majority of these patients are treated with conservative
pain management therapies.  These methods do not involve surgical intervention
and do not repair the fractured spine.  These pain management 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 health care;
- physical therapy;
- exercise;
- chiropractic care; and
- radiation in cancer patients.

Pain management 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.

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 spine fractures.

In vertebroplasty, a physician, typically an interventional radiologist,
places one or two large needles into the fractured vertebra and injects bone
filler material into the collapsed vertebral body.  The bone filler most
commonly used in vertebroplasty is bone cement.  Because the vertebral body is
in a collapsed position, this procedure requires the use of thin bone filler
material that is injected under high pressure in order to effectively penetrate
the inner spaces of the deteriorated bone.  A non-viscous filler material
injected under high pressure into the vertebral body can result in leakage, as
documented in literature.  Once injected, the bone filler material hardens and
fixes the bone in its collapsed position.

The Kyphon Solution

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

Minimally invasive spine fracture surgeries using our KyphX
instruments typically involve the insertion of two of our disposable proprietary
balloon devices into the fractured bone, although only one balloon may be used
occasionally.  The surgeon 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 surgeon'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 Food and Drug Administration
("FDA") in the U.S. for kyphoplasty.

We have trained more than 5,600 physicians, including approximately 1,700
overseas in the use of our KyphX instruments.  We believe these
physicians have used our instruments in over 110,000 kyphoplasty surgeries
involving spine fractures.

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 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 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 897 patients treated with kyphoplasty and
2,408 patients treated with vertebroplasty.  The data in the published
literature demonstrates that 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
kyphoplasty.  As a result, we have now introduced the corresponding comparative
claims into our educational and marketing materials.

The Use of KyphX Instruments during Minimally Invasive Kyphoplasty
Spine Surgery

Spine fracture surgeries using our KyphX instruments are minimally
invasive and are generally performed by spine-focused orthopedic surgeons and
neurosurgeons, although the number of interventional radiologists and
interventional neuroradiologists using our products to perform kyphoplasty is
increasing.  A surgeon first creates a working channel through the patient's
back into the fractured vertebral body using one of our KyphX Bone Access
Systems.

The surgeon 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.  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.

Our Strategy

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

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

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

- Educate Primary Care Physicians with our Spine Educational Field
Force

- Expand Marketing Claims

- Support Appropriate Levels of Physician Reimbursement in the United
States

- Expand our global commercial reach

- Continue Revenue Growth Through New Product Development and
Acquisition

Our Products

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

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 orthopedic 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.  Products
introduced during 2004 include the KyphX Elevate Inflatable Bone
Tamp, the KyphX Exact Inflatable Bone Tamp, and the KyphX
Express Inflatable Bone Tamp, all of which are variations of the basic
KyphX Xpander Inflatable Bone Tamp.

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 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 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.

Sales and Marketing

We market and sell our KyphX instruments through our direct sales
force in the United States and Europe that numbers in excess of 350
professionals as of December 31, 2004.  Our target customer base includes the approximately 6,000 to
7,000 physicians who perform spine surgery, including orthopedic spine surgeons,
neurosurgeons, interventional radiologists and interventional neuroradiologists.
No customer accounted for more than 10%  of total net sales in 2004, 2003 or
2002.

Our U.S. sales organization is currently comprised
of 168 sales territories.  Each territory is managed
by a spine consultant who acts 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.  In 2003, we initiated
a spine education specialist program whereby selected
sales representatives call on primary care physicians to educate them about our
KyphX instruments.  As of December 31, 2004, we had expanded the number
of our U.S. sales force personnel involved in this program to approximately 60
individuals in the United States.  We have also trained more than 5,600
physicians in the U.S., Europe and Asia Pacific to perform the kyphoplasty
procedure with our KyphX instruments.

We have operated mainly in the United States, and 88%, 90% and 93% of our
sales were made in U.S. dollars in 2004, 2003 and 2002, respectively.  The
majority of our international sales are derived from European Union countries.
Our European operations are 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 still in the very 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 also formed our Canadian subsidiary
and have begun to sell our products in Canada through a direct sales force.  In
2005, we plan to begin selling our products in Brazil and Mexico through
distributors, and to investigate other selected South American and Asia-Pacific
countries regarding potential product selling activities.

Reimbursement

Establishing reimbursement for any new medical technology is a challenge in
the current environment of cost containment, managed care and Medicare.  To
successfully establish reimbursement coverage, we must prove that our technology
improves health outcomes, such as quality of life or functional ability, and
does so in a cost-effective manner.

Payment for patient care in the United States is generally made by private
insurers.  These insurers act on their own behalf or under contract with the
U.S. government to administer the Medicare program.  Medicare covers most of the
medical expenses of individuals ages 65 and over.  Approximately 90% of patients
with spine fractures caused by osteoporosis are covered by Medicare, while the
rest are covered primarily by private insurers.  Private insurers often follow
the coverage and payment policies of Medicare.  Most patients with spine
fractures caused by cancer and trauma are covered by private insurers.

For inpatient and outpatient spine fracture reduction procedures, the Center
for Medicare and Medicaid Services ("CMS"), reimburses hospitals for a
prospectively determined amount, regardless of the actual cost for such
treatment, based primarily on the patient's diagnosis and the nature of the care
provided during the hospital stay.  We receive payment directly from the
hospital for our instruments, and Medicare reimburses the hospital for its costs
of admitting (for inpatient procedures) and treating the patient, whether
inpatient or outpatient, including the purchase of our instruments, under
existing applicable codes.  The physician who performs the procedure is
reimbursed under a different system that is based on procedure codes, called
current procedural terminology, or CPT, codes.  Government imposed limits on
reimbursement of hospitals and other health care providers have significantly
impacted the willingness of hospitals, clinics and doctors to utilize
technologies and procedures that are not eligible for appropriate levels of
Medicare reimbursement.

In all 50 states and in the District of Columbia, Medicare reimburses
physicians at varying payment levels for their services when they perform
procedures using our KyphX instruments.  Currently, Medicare reimburses
physicians who use our KyphX instruments on a state-by-state basis.  This
form of reimbursement is not uniform across all states because there is
presently no national CPT code or associated national payment rate relating to
procedures using our instruments, and a national CPT code may not exist for some
time.  As a result, unless a state has a published policy regarding
reimbursement, physicians must report procedures using our instruments under an
unlisted CPT code, submit their bills for review and request payment based on
the time, work and risk involved in the procedure.  We intend to continue to use
the results of future clinical studies, peer-reviewed physician journal
articles, and support from leading physicians who are familiar with our
KyphX instruments to further support physician reimbursement for
procedures using our instruments.  In addition, in 2004, medical societies
familiar with the kyphoplasty procedure applied for the establishment of a
national payment rate through a CPT code.  In the fourth quarter of 2004, the
AMA CPT Editorial Panel considered
multiple applications for a national CPT code for spine specialist reimbursement
for kyphoplasty, which is the initial step in the CPT process.  We have learned
that the AMA CPT Editorial Panel has decided to support the establishment of a
national CPT code for kyphoplasty.  We also understand that the relative value
survey process involving input from the medical community regarding the
kyphoplasty procedure, may begin in the first or second quarter of 2005.  We
understand that upon conclusion of the survey process and determination of the
appropriate reimbursement level, the results may be publicly communicated in the
fourth quarter of 2005 in the Federal Register.  Despite these developments, we
cannot be certain that a CPT code for kyphoplasty with an associated value ultimately would become
effective in 2006, or at all.  We also cannot assure you that the establishment
of a national CPT code, if any, would be beneficial to our business since the
reimbursement level associated with the national CPT code could be less than
what physicians in some states are presently receiving and may not be deemed
sufficient by physicians to justify the use of our products to perform
kyphoplasty.

Manufacturing

We believe our manufacturing operations are in compliance with regulations
mandated by the FDA and the European Union.  We have been an FDA-registered
and California-licensed medical device manufacturer since 1998 and have had our
CE Mark since February 2000.  We had our annual TUV audit in April 2004
with no non-compliance reports issued, continuing our facility as ISO 13485:1996
certified.  In January 2005, we received ISO 13485:2003 certification of
our manufacturing facilities.  We are subject to unannounced inspections by
the FDA, TUV 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.  We have been inspected by the CDHS, the
FDA and European auditors and there have been no significant 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 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 appropriately 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 creating new products, product
extensions and improvements to existing products to address unmet patient and
market needs 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, including but not necessarily limited to, treatment of spinal
fractures and other spinal deformities and disease states.  In addition, we
intend to further develop balloon and related technologies to treat various
other bone disorders arising from trauma or cancer.  Our expenditure for
research and development totaled $22.0 million, $15.2 million and $10.1 million
in 2004, 2003 and 2002, respectively.  We are currently developing the following
products:

- 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 biomaterials designed for spine surgery in patients with
cancer in the spine; and
- instruments and biomaterials for the treatment of spinal disc
disease.

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

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 spine fracture treatments.  We also are beginning to
see interest by third parties in introducing into the marketplace 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 kyphoplasty.  Competition is likely to increase
the awareness and frequency of alternative procedures to kyphoplasty.  We are
also beginning to see introduction by competitors of instruments designed to
achieve both void creation and fracture reduction.  Particularly in Europe,
these products are initially being marketed as more effective and less expensive
than our KyphX products although limited entry into the U.S. market has
also begun for some of these 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 spine fractures over time.

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, reimbursement status, efficacy 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 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
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, 2004, we had 37 issued U.S.
patents, 28 issued foreign patents, 51 pending U.S. patent
applications, 114 pending foreign applications and 26 patents that we
exclusively licensed from Bonutti Research in August 2002.

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 orthopedic applications in joints, ligaments, cartilage, nerves or
tendons outside of the spine.

In February 2003, we acquired Sanatis GmbH, a privately-held developer
and manufacturer of orthopedic biomaterials based in Rosbach, Germany.  Sanatis
has filed four patent applications covering inventions relating to calcium
cement formulations and a cement delivery 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 noninfringing 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 noninfringing
technologies could prevent us from manufacturing and selling our products, which
would have a material adverse effect on our business, results of operations and
financial condition.

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 a
premarket notification requesting permission for commercial distribution; this
is known as 510(k) clearance.  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 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
kyphoplasty with KyphX HV-RBone Cement), hand, tibia, radius and
calcaneus.  The KyphX Inflation Syringe and 11 Gauge Bone Access Needle
are 510(k)-cleared products that we currently obtain from contract suppliers.
We believe our KyphX Introducer Tool Kit, Osteo Introducer System,
Advanced Osteo Introducer System, Bone Biopsy Device, Latitude
Curette, and KyphX Bone Filler Device, when sold as manual orthopedic
surgical instruments, are exempt from clearance or approval requirements.  Our
510(k) clearances permit us to promote particular short and long-term benefits
of kyphoplasty, 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.

Premarket Approval. A premarket approval application, or PMA,
must be submitted if the 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, and manufacturing 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 most 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 quality
system regulations and may also conduct inspections of the clinical
investigators' and study sponsors' sites.  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
elaborate testing, control, documentation and other quality assurance procedures
during the manufacturing process;
- 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 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 relatively low number of MDRs for
our products; more may be required as the number of procedures performed with
our products increases.  Through 2004, 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.

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 15 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 adopted numerous directives and standards regulating the
design, manufacture, clinical trial, labeling and adverse event reporting for
medical devices.  Devices that comply with the requirements of a relevant
directive will be entitled to bear CE conformity marking, indicating that the
device conforms to the essential 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 may consist of an
audit of the manufacturer's quality system and specific testing of the
manufacturer's product.  An assessment by a Notified Body 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 designated manufacturing and quality requirements known as "ISO"
requirements.

We have obtained CE Marking permitting us to commercialize our products
currently being sold 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.

Employees

As of December 31, 2004, we had a total of 706 employees, with 108 people in
operations, 65 people in research and development, 433 people in sales,
marketing and professional education and 100 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 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 possible after they are
filed with the SEC.

ITEM 2.	PROPERTIES

Our United States operations and our corporate headquarters are located
in an approximately 107,000 square foot facility in Sunnyvale, California, where
we conduct our manufacturing, warehousing, research, regulatory and
administrative activities.  The facility is leased through August 2014.  Under
the terms of the lease agreement, we have the option to rent an adjacent
existing facility as well as an option to have additional square footage built
and leased to us in the same surrounding campus.

Our European operations are located in an approximately 22,000
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
most of the major countries in Europe and offices in Japan and Canada, expiring
at various dates through 2013.

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 April 2004, we filed two patent infringement suits against Disc-O-Tech
Medical Technologies Ltd., an Israel-based company doing business in the United
States as Disc Orthopaedic Technologies Inc. ("Disc-O-Tech").  We
filed suit in the United States District Court in Delaware and in the
International Trade Commission ("ITC") in Washington, D.C.  In
September 2004, the ITC entered an Order barring Disc-O-Tech from all further
importation of its SKy Bone Expander device into the United States and from
engaging in any further sales activities and uses of such imported products,
which thereby terminated the ITC proceeding in our favor.  An enforcement
proceeding against Disc-O-Tech in the ITC may later be initiated if it is
determined that Disc-O-Tech is not complying fully with the ITC Order.  In
Delaware, our complaint presently alleges, among other things, that by
importing, manufacturing, distributing and promoting its SKy Bone Expander
device and related tools for use in kyphoplasty procedures, Disc-O-Tech is
willfully infringing five of our U.S. patents, all of which generally concern
the use of various medical devices to repair spinal compression fractures, and
seeks enhanced damages and a permanent injunction for its willful infringement.
Trial is set for June 2005.  We are using the information discovered during the
ITC proceeding about Disc-O-Tech's business activities to prosecute our case
against Disc-O-Tech in Delaware and will continue to do so vigorously.  Costs
related to this litigation will be dilutive to our earnings.

We are presently party to no other material litigation.

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 National 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 National Market:

`Common Stock
                                                       --------------------
                                                         High        Low
Fiscal Year 2003                                       ---------  ---------
First quarter                                         $   11.00  $    7.64
Second quarter                                        $   14.87  $    8.10
Third quarter                                         $   25.85  $   15.14
Fourth quarter                                        $   29.40  $   20.56

Fiscal Year 2004                                                           
First quarter                                         $   30.28  $   20.83
Second quarter                                        $   29.37  $   22.38
Third quarter                                         $   28.51  $   22.22
Fourth quarter                                        $   26.55  $   22.93`





We had 139 stockholders of record as of February 15, 2005.

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 and do not anticipate paying any
cash dividends in the foreseeable future.

The information required by this item regarding securities authorized for
issuance under equity compensation plans is incorporated by reference to the
information set forth in Item 12 of this Annual Report on Form 10-K.

We did not sell any unregistered securities during the period covered by this
Annual Report on Form 10-K.

On May 17, 2002, we completed our initial public offering, including exercise
of the underwriters' over-allotment option, of 6,900,000 shares at an initial
public offering price of $15.00 per share, for aggregate cash proceeds of
approximately $103.4 million.  Our managing underwriters for the offering were
U.S. Bancorp Piper Jaffray Inc., Banc of America Securities LLC and Bear,
Stearns & Co. Inc.  In connection with the offering, we paid approximately
$7.2 million in underwriting discounts and commissions and approximately $1.3
million in other offering costs.  After deducting the underwriting discounts and
commissions and the offering costs, our net proceeds from the offering,
including the over-allotment option, were approximately $94.9 million.  As of
December 31, 2004, all proceeds from the offering had been utilized.

Our Board of Directors approved a stock repurchase program on November 7,
2002 pursuant to which up to 2,000,000 shares of our outstanding common stock
may be repurchased from time to time.  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.  No shares were repurchased under this program in 2004 or 2003.  In
2002, we repurchased 30,000 shares pursuant to this repurchase program.

ITEM 6.	SELECTED CONSOLIDATED FINANCIAL DATA

The following tables reflect 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, 2004,
2003 and 2002, and the consolidated balance sheet data as of December 31, 2004
and 2003 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, 2001 and 2000, and the consolidated
balance sheet data as of December 31, 2002, 2001 and 2000 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 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.

`Year Ended December 31,
                                                      ----------------------------------------------------------
                                                         2004        2003        2002        2001        2000
                                                      ----------  ----------  ----------  ----------  ----------
                                                                   (in thousands, except per share amounts)
Consolidated Statement of Operations Data:                                                                      
Net sales                                            $  213,414  $  131,028  $   76,316  $   36,073  $    6,076
Cost of goods sold                                       24,734      16,794      10,416       8,108       3,606
                                                      ----------  ----------  ----------  ----------  ----------
Gross profit                                            188,680     114,234      65,900      27,965       2,470
                                                      ----------  ----------  ----------  ----------  ----------
Operating expenses:
  Research and development                               22,043      15,237      10,145       7,859       4,516
  Sales and marketing                                   104,299      68,676      43,509      27,891      11,399
  General and administrative                             27,971      17,348      12,540       9,720       5,343
  Purchased in-process research and development              --         636      12,250          --          --
                                                      ----------  ----------  ----------  ----------  ----------
      Total operating expenses                          154,313     101,897      78,444      45,470      21,258
                                                      ----------  ----------  ----------  ----------  ----------
Income (loss) from operations                            34,367      12,337     (12,544)    (17,505)    (18,788)
Interest income (expense) and other, net                  1,250         986      (2,794)       (309)      1,086
                                                      ----------  ----------  ----------  ----------  ----------
Net income (loss) before income taxes                    35,617      13,323     (15,338)    (17,814)    (17,702)
Provision (benefit) for income taxes                     13,900     (14,000)         --          --          --
                                                      ----------  ----------  ----------  ----------  ----------
Net income (loss)                                    $   21,717  $   27,323  $  (15,338) $  (17,814) $  (17,702)
                                                      ==========  ==========  ==========  ==========  ==========

Net income (loss) per share:
  Basic                                              $     0.54  $     0.71  $    (0.63) $    (9.06) $   (15.55)
                                                      ==========  ==========  ==========  ==========  ==========
  Diluted                                            $     0.50  $     0.65  $    (0.63) $    (9.06) $   (15.55)
                                                      ==========  ==========  ==========  ==========  ==========
Weighted-average shares outstanding:
  Basic                                                  40,449      38,433      24,405       1,967       1,139
                                                      ==========  ==========  ==========  ==========  ==========
  Diluted                                                43,670      42,090      24,405       1,967       1,139
                                                      ==========  ==========  ==========  ==========  ==========

                                                                          As of December 31,
                                                      ----------------------------------------------------------
                                                         2004        2003        2002        2001        2000
                                                      ----------  ----------  ----------  ----------  ----------
                                                                              (in thousands)
Consolidated Balance Sheet Data:                                                                                
Cash, cash equivalents and investments               $  115,799  $   85,479  $   74,303  $    3,352  $    8,898
Working capital (deficit)                               153,926      86,564      83,504      (5,623)     10,213
Total assets                                            213,389     154,480     101,524      18,287      15,195
Convertible promissory notes                                 --          --          --      12,000          --
Long-term debt                                               --          --          --          43         132
Redeemable convertible preferred stock                       --          --          --      38,024      38,024
Deferred stock-based compensation, net                   (2,113)     (6,435)    (11,947)    (16,082)     (6,781)
Total stockholders' equity (deficit)                 $  179,635  $  134,250  $   91,514  $  (37,667) $  (25,134)`



ITEM 7.	MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS

Introduction

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 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 and
our plans to pursue research, development and commercialization of additional
spine products developed internally or arising from acquisitions.  In some
cases, forward-looking statements can be identified by the use of forward-
looking terminology such as "believe," "estimate,"
"may," "can," "will," "intend,"
"objective," "plan," "expect" or
"anticipate" or the negative of these terms or other comparable
terminology.  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 "Management's Discussion and Analysis of
Financial Condition and Results of Operations - Factors Affecting Future
Operating Results", ("MD&A") section of this report.  The
reader is cautioned not to place undue reliance on these forward looking
statements, which reflect management's analysis only as of the date of this
Annual Report on 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.  MD&A is organized as follows:

- Executive summary.
- Results of operations.
- Deferred and stock-based compensation.
- Seasonality.
- Liquidity and capital resources.
- Recent accounting pronouncements.
- Critical accounting policies and estimates.
- 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 using minimally invasive technology.  Our
devices are presently used primarily by spine specialists including orthopedic
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 known as kyphoplasty procedures.  Our commercial products consist of
our KyphX instruments used to treat spine fractures during kyphoplasty,
including our proprietary KyphX balloon technology and our proprietary
brands of bone filler materials.  Surgeons use these instruments and bone filler
materials to help repair fractures during kyphoplasty procedures.  Most
alternative spine fracture treatments are either highly invasive or are only
pain management therapies.

Our corporate headquarters and U.S. operations are located in Sunnyvale,
California, where we conduct our manufacturing, warehousing, research,
regulatory and administrative activities.  Outside the U.S., we operate sales,
clinical, regulatory and administrative facilities in Brussels, Belgium,
research and biomaterial manufacturing facilities in Rosbach, Germany, a
clinical, regulatory and administrative facility in Japan, and we have direct
selling operations in most of the major countries in Europe and in Canada.  Our
global distribution network consists of a direct sales force in excess of 350
individuals who market our products in the U.S., most of the major countries in
Europe, Canada and Japan and distributors and sales agents in other countries in
which we do not have a direct sales force.



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

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

Effective October 1, 2004, Louis J. Lavigne, Jr., Executive Vice President
and Chief Financial Officer of Genentech, Inc., was appointed to our Board of
Directors as Chairman of the Audit Committee and a member of the Board's
Nominating and Corporate Governance Committee.

In the fourth quarter of 2004, we adjusted the responsibilities of
some of our executive team to better serve our needs.  Bert Vandervelde
took over responsibility for all of our activities outside of the U.S., as Vice
President and General Manager, International.  Elizabeth A. Rothwell, Vice
President, Operations, assumed responsibility for our research and
development activities, to permit Avram A. Edidin to focus on external
development opportunities as Vice President, Emerging Technologies.  Bradley W.
Paddock, employed by us for over five years in various sales capacities and
intimately familiar with our sales strategies and objectives, assumed the
position of Vice President, U.S. Sales, following the resignation
of Anthony J. Recupero to pursue other business opportunities,
effective December 31, 2004.  Mr. Recupero remains a consultant to Kyphon
through June 2006.  We may make further adjustments to the responsibilities and
reporting structure of our executive team as we continue to grow.

Products and Significant Business Trends.  Our net sales consist 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 and KyphX Bone
Biopsy Device, as well as our recently cleared KyphX HV-R Bone Cement and
our CE-Marked KyphOs calcium phosphate from our acquisition of Sanatis.

During 2004, our business experienced significant growth.  Net sales in 2004
increased to $213.4 million, compared to $131.0 million in 2003,
representing growth of 63%.  We trained approximately 1,700 physicians to use
our products during 2004 in the United States and Europe.  In the U.S., we added
over 350 new hospitals to our customer base during that same period.  We
continued a program whereby additional spine education specialists were hired
with a primary role of educating referring primary care physicians and other
medical advisors on kyphoplasty as an alternative to conventional spine fracture
treatment and conservative pain management therapies.

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

Recently, we concluded an extensive review of the published clinical
literature describing the results for 897 patients treated with kyphoplasty and
2,408 patients treated with vertebroplasty.  The data in the published
literature demonstrates that 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.  As a result, we have now introduced the corresponding
comparative claims into our educational and marketing materials.

In April 2004, we filed two patent infringement suits against Disc-O-Tech, an
Israel-based company doing business in the United States.  We filed suit in the
United States District Court in Delaware and in the ITC in Washington, D.C.  In
September 2004, the ITC entered an Order barring Disc-O-Tech from all further
importation of its SKy Bone Expander device into the United States and from
engaging in any further sales activities and uses of such imported products,
which thereby terminated the ITC proceeding in our favor.  An enforcement
proceeding against Disc-O-Tech in the ITC may later be initiated if it is
determined that Disc-O-Tech is not complying fully with the ITC Order.  In
Delaware, our complaint presently alleges, among other things, that by
importing, manufacturing, distributing and promoting its SKy Bone Expander
device and related tools for use in kyphoplasty procedures, Disc-O-Tech is
willfully infringing five of our U.S. patents, all of which generally concern
the use of various medical devices to repair spinal compression fractures, and
seeks enhanced damages and a permanent injunction for its willful infringement.
Trial is set for June 2005.  We are using the information discovered during the
ITC proceeding about Disc-O-Tech's business activities to prosecute our case
against Disc-O-Tech in Delaware and will continue to do so vigorously.  Costs
related to this litigation will be dilutive to our earnings.

In addition to Disc-O-Tech, several other companies either have already
introduced one or more products into the U.S. and/or foreign markets to compete
with our KyphX instruments for treating vertebral fractures or may be on
the verge of doing so.  To the extent any competing products infringe our
patents; we will consider how best to protect our market space as well as
whether to take action against any potentially infringing activities.  As a
result, we may decide that litigation or other legal activity to seek to protect
and enforce our rights, in addition to our ongoing actions against Disc-O-Tech,
would be appropriate.  Regardless of if we do so, however, we likely will have
to compete with these competitive products for some period of time and may
ultimately not succeed in enforcing our rights.  We may not have the ability to
prevent those products from remaining on the market in at least some geographic
locations, and we may lose market share or have our growth impeded as a result.

We have had several recent encouraging developments related to reimbursement
for our products.  First, in May 2004, the Centers for Medicare and Medicaid
Services ("CMS") ICD-9 Coordination and Maintenance Committee issued
and published a recommendation for a specific ICD-9-CM in-patient procedure code
for the kyphoplasty procedure.  On August 11, 2004, this rule was approved and
the kyphoplasty procedure was assigned ICD-9-CM code 81.66 to go into effect on
October 1, 2004.  This code was assigned to the following five diagnosis related
group ("DRG") codes: 233, 234, 442, 443 and 486.  DRG codes establish
the payment levels that hospitals can claim reimbursement from Medicare and
Medicaid and are in turn, key factors in determining reimbursement levels and
ultimately the quantity of products used in procedures such as kyphoplasty.  At
this time it is not yet clear how each of these codes will be applied,
especially 442, 443 and 486, which are new.  We anticipate increased
clarification as more information becomes available from CMS in the next few
months.

Second, in November 2004, CMS published the Final Rule on the Medical
Hospital Outpatient Prospective System and created new and
distinct hospital outpatient procedure codes for kyphoplasty, C9718 and C9719.
These new C-codes are assigned to APC 51 and are effective January 1, 2005.  At
the reimbursement level presently in effect, we do not anticipate that many
kyphoplasty procedures will be performed on an outpatient basis.

On a national level, the Healthcare Common Procedure Coding System
("HCPCS") National Editorial Panel established two new HCPCS
"S" codes for kyphoplasty effective January 1, 2004.  These S codes
are intended for use by private payors, such as the Blue Cross Blue Shield
Association and the Health Insurance Association of America, although no payment
level is associated with these codes.  In addition, policy and/or bulletin
coverage is now established in 40 states, with the remaining states providing
coverage on a case-by-case basis.  The private payor community has also shown
significant interest in establishing reimbursement policies for kyphoplasty.
Specifically, Blue Cross Blue Shield has now adopted policy coverage for
kyphoplasty in 31 states, and a number of private payors nationwide have also
adopted policy coverage.  However, there are some private payors that may
continue to perceive the procedure which uses our products as experimental and
thus not subject to reimbursement.  Another challenge we face is to achieve
consistent and/or increased payment levels among the different insurers.  We
continue to focus on addressing these issues.

There was also progress in surgeon reimbursement during 2004.  Presently, no
national CPT code exists for spine
specialist reimbursement under Medicare for performing kyphoplasty, and a CPT
code may not exist for some time.  Physicians presently must report procedures
using our instruments under an unlisted CPT code.  In the fourth quarter of
2004, the AMA CPT Editorial Panel considered multiple applications for a
national CPT code for spine specialist reimbursement for kyphoplasty, which is
the initial step in the CPT process.  We have learned that the AMA CPT Editorial
Panel has decided to support the establishment of a national CPT code for
kyphoplasty.  We also understand that the relative value survey process
involving input from the medical community regarding the kyphoplasty procedure
may begin in the first or second quarter of 2005. We understand that upon
conclusion of the survey process and determination of the appropriate
reimbursement level, the results may be publicly communicated in the fourth
quarter of 2005 in the Federal Register.  Despite these developments, we cannot
be certain that a CPT code for kyphoplasty with an associated value ultimately will become effective in
2006 or at all.  While we perceive this AMA CPT Editorial Panel support for the
establishment of a national CPT code for kyphoplasty to be significant progress,
we cannot be certain what action will ultimately taken, or how any action
taken may affect our marketplace or our business, or whether any CPT code
ultimately would increase or decrease any of the spine specialist reimbursement
already available.  Any CPT code has at least the potential to be detrimental to
spine specialist reimbursement, and thus to our revenues.

In Europe, kyphoplasty was assigned a code in the newly 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 one or more competitors is attempting 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 for
our products in those markets.  We do not know whether these efforts will
continue, be effective or broad in application.  Notwithstanding these
activities, we will continue to seek appropriate levels of reimbursement in
those markets using appropriate measures.

We frequently evaluate potential opportunities for growth in our business by
evaluating external products and technologies.  While our primary focus will
remain on our core business and the large opportunities the osteoporosis, cancer
and trauma vertebral fracture markets present, we may choose to pursue one or
more business development opportunities which we believe are appropriate
initiatives for our business, even if outside of the field for the treatment of
spinal fractures or outside of the spine itself.  Some of the opportunities we
are presently investigating include technologies and products that address
degenerative disc disease and various cancers associated with our core market.
These efforts may require us to seek additional funding and may be dilutive to
our earnings.

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

Results of Operations

Changes to Previously Announced Fiscal 2004 Fourth Quarter and Annual
Results

On February 7, 2005, we announced our fiscal 2004 fourth quarter and annual
results.  On February 8, 2005, the SEC issued additional guidance regarding
accounting for incentives associated with operating leases.  In light of this
guidance, we concluded that reflecting an additional $2.9 million in long-term
liabilities and a corresponding $2.9 million of additional property and
equipment was appropriate.  This adjustment related to a reimbursement received
from our lessor in 2004 in conjunction with the lease of our headquarters in
Sunnyvale, California.  In conjunction with this lease, we received cash
incentives from our landlord to be used for leasehold improvements.  These
amounts have now been reflected as additional deferred rent and additional
property and equipment and are being amortized to rent expense and depreciation
expense over the term of our operating lease, respectively.



There was no change to our fiscal 2004 fourth quarter and annual net income
or earnings per share as previously announced.

Comparison of years ended December 31, 2004, 2003 and 2002

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,
                                                    ------------------------------------------------------------------
                                                             2004                   2003                   2002
                                                    --------------------   --------------------   --------------------
                                                                 % of                   % of                   % of
                                                     Amount    Net sales    Amount    Net sales    Amount    Net sales
                                                    ---------  ---------   ---------  ---------   ---------  --------- 
U.S. net sales                                     $ 187,526         88 % $ 118,422         90 % $  70,850         93 %
International net sales                               25,888         12 %    12,606         10 %     5,466          7 %
                                                    ---------  ---------   ---------  ---------   ---------  ---------
Net sales                                            213,414        100 %   131,028        100 %    76,316        100 %
Cost of goods sold                                    24,734         12 %    16,794         13 %    10,416         14 %
                                                    ---------  ---------   ---------  ---------   ---------  ---------

Gross profit                                         188,680         88 %   114,234         87 %    65,900         86 %
                                                    ---------  ---------   ---------  ---------   ---------  ---------

Operating expenses:
  Research and development                            22,043         10 %    15,237         12 %    10,145         13 %
  Sales and marketing                                104,299         49 %    68,676         52 %    43,509         57 %
  General and administrative                          27,971         13 %    17,348         13 %    12,540         17 %
  Purchased in-process research and development           --         -- %       636          1 %    12,250         16 %
                                                    ---------  ---------   ---------  ---------   ---------  ---------
      Total operating expenses                       154,313         72 %   101,897         78 %    78,444        103 %
                                                    ---------  ---------   ---------  ---------   ---------  ---------

Income (loss) from operations                         34,367         16 %    12,337          9 %   (12,544)       (16)%
Other and interest income (expense), net               1,250          1 %       986          1 %    (2,794)        (4)%
                                                    ---------  ---------   ---------  ---------   ---------  ---------

Net income (loss) before income taxes                 35,617         17 %    13,323         10 %   (15,338)       (20)%
Provision (benefit) for income taxes                  13,900          7 %   (14,000)       (11)%        --         -- %
                                                    ---------  ---------   ---------  ---------   ---------  ---------
Net income (loss)                                  $  21,717         10 % $  27,323         21 % $ (15,338)       (20)%
                                                    =========  =========   =========  =========   =========  =========`



Net Sales. Net sales increased $82.4 million, or 63%, in 2004
compared to 2003, and increased $54.7 million, or 72%, in 2003 compared to 2002.
The increases in net sales primarily resulted from an increase in the number of
physicians trained in the use of our KyphX instruments as well as an
increase in the number of procedures performed by trained physicians.  In
addition, net sales increased due to the introduction of new products and to a
much lesser extent selected product price increases.  Domestic sales increased
$69.1 million, or 58% in 2004 compared to 2003 and $47.6 million, or 67% in 2003
compared to 2002.  International sales increased $13.3 million, or 105% in 2004
compared to 2003 and $7.1 million, or 131% in 2003 compared to 2002.  The
increase in international sales also reflected the currency impact of $2.6
million and $1.9 million in 2004 and 2003, respectively, as the Euro exchange
rate continued to strengthen against the U.S. dollar.  No customer accounted for
more than 10% of total net sales in 2004, 2003 or 2002.  As of December 31,
2004, we had trained approximately 3,900 spine specialists in the U.S. and
approximately 1,700 clinicians in other parts of the world, primarily Europe.
These physicians have used our KyphX instruments in over 110,000 spine
surgeries since we first introduced our products.   We believe the total number
of potential physicians who may perform kyphoplasty procedures using our
products is approximately 5,000 to 5,500 in the U.S.  The number of physicians
in Europe is less defined at this time, but we believe them to be more than
3,000.  We have targeted a range of $280 million to $295 million in net sales
for 2005.

Cost of Goods Sold. Cost of goods sold consists of material,
labor, subcontract, and overhead costs.  Cost of goods sold increased $7.9
million, or 47%, in 2004 compared to 2003, and increased $6.4 million, or 61%,
in 2003 compared to 2002.  However, cost of goods sold as a percentage of net
sales continued to decrease primarily as a result of fixed overhead costs being
spread over increased production volume.  The absolute increase in cost of goods
sold over the years from 2002 to 2004 resulted primarily from increased
material, labor, subcontract, overhead costs and inventory provisions in
relation to the increased sales volume of our products.  Our cost of goods sold
and corresponding gross profit percentages can be expected to fluctuate in
future periods depending upon changes in our product sales mix and prices,
distribution channels and geographies, manufacturing yields, period expenses and
levels of production volume.

Research and Development.  Research and development expenses
consist of costs for product research, product development, regulatory and
clinical functions and personnel.  Research and development expenses increased
$6.8 million, or 45%, in 2004 compared to 2003.  Research and development
expenses increased $5.1 million, or 50%, in 2003 compared to 2002.  The increase
in 2004 from 2003 was primarily attributable to increased personnel costs of
$3.4 million, increased clinical studies expense of $2.3 million, increased
research and development consulting fees of $926,000 and increased facilities
costs of $618,000, offset by a decrease in amortization of deferred stock-based
compensation expense of $1.1 million.  The increase in 2003 from 2002 was
primarily attributable to increased personnel costs of $1.7 million, increased
research and development consulting fees of $858,000, increased product testing
and development expenditures of $831,000, and increased basic and applied
research funding of $582,000.  We expect to continue to make substantial
investments in research and development and anticipate that research and
development expenses in 2005 will increase in absolute dollars due largely to
the commencement of clinical studies.  As a percentage of targeted net sales, we
anticipate our research and development expenses to be in the range of 10% to
11% for 2005.

Sales and Marketing.  Sales and marketing expenses consist of
costs for personnel, physician training programs and marketing activities.
Sales and marketing expenses increased $35.6 million, or 52%, in 2004 compared
to 2003.  Sales and marketing expenses increased $25.2 million, or 58%, in 2003
compared to 2002.  The increase in 2004 from 2003 related primarily to a $25.0
million increase in the costs of hiring, training and compensating additional
direct selling representatives and expansion of the Spine Education Specialist
sales force, increased sales travel expenses of $3.8 million, increased
expenditures for surgeon training and professional education of $2.1 million and
increased outside professional service fees and consulting expenses of $1.2
million. The increase in 2003 from 2002 related primarily to a $17.1 million
increase in the costs of hiring, training and compensating additional direct
selling representatives, increased expenditures related to advertising,
promotion, trade shows and market research activities of $4.0 million, increased
sales travel expenses of $2.0 million, and increased consulting expenses of $1.3
million.  As we continue to commercialize our KyphX instruments on a
global basis during 2005, we expect to significantly increase our sales and
marketing efforts and expenditures in absolute dollars while maintaining our
sales and marketing expenses as a percentage of targeted net sales at 48% to 49%
for the year.

General and Administrative.  General and administrative
expenses consist of personnel costs, professional service fees, expenses related
to intellectual property rights, Sarbanes-Oxley compliance initiatives and
general corporate expenses.  General and administrative expenses increased $10.6
million, or 61%, in 2004 compared to 2003.  General and administrative expenses
increased $4.8 million, or 38%, in 2003 compared to 2002.  The increase in 2004
from 2003 was primarily attributable to increased personnel costs of $4.2
million, increased litigation costs of $2.6 million and increased consulting and
outside professional service fees of $2.0 million.  The increases in expenses
were offset partially by decreased amortization of deferred stock-based
compensation of $213,000.  The increase in 2003 from 2002 resulted primarily
from increased personnel costs of $1.5 million, increased facility expenses of
$587,000, increased licenses and insurance expenditures of $581,000, increased
travel and entertainment expenses of $552,000, and facility expense of $1.2
million due to an early lease termination as a result of our decision to move to
a larger facility.  We expect general and administrative expenses to increase in
the future as we add personnel, continue to expand our patent portfolio and
incur additional public reporting, governmental compliance and investor-related
expenses as a public company.  Therefore, we anticipate that our general and
administrative expenses will increase in absolute dollars as we expand our
infrastructure.  As a percentage of targeted net sales, we expect that our
general and administrative expenses will be approximately 12% to 13% in
2005.

Purchased In-Process Research and Development.   We did not
purchase additional in-process research and development in 2004.  In February
2003, we purchased Sanatis GmbH, for approximately $4.7 million in cash and
acquisition costs of $201,000.  Sanatis is a privately-held developer and
manufacturer of orthopedic biomaterials based in Rosbach, Germany.  The
acquisition was made to add Sanatis' experience developing and manufacturing
orthopedic biomaterials and to complement our existing patent portfolio with
Sanatis' intellectual property surrounding calcium-based biomaterials and
delivery technologies.  The impact to our financial operating results during
2003 was an increase in research and development of approximately $624,000.  We
have recorded the transaction using the purchase method of accounting.  At the
time of this transaction, we recorded an expense associated with the purchase of
in-process research and development expenses of $636,000, and we capitalized net
tangible assets of $176,000, intangible assets of $142,000 and goodwill of $4.1
million.  We are amortizing the intangible assets on a straight line basis over
a five-year period.  No amortization of goodwill has been recorded.  Instead, we
perform an assessment for impairment by applying a fair-value based test
annually, or more frequently, if changes in circumstances or the occurrence of
events suggests the remaining value is not recoverable.  The annual goodwill impairment test was completed in the first
quarter of fiscal 2004, and it was determined that there was no impairment of
goodwill at that time.



In August 2002, we entered into a patent license agreement with Bonutti
Research Inc. for the rights to a series of patents issued to Dr. Peter Bonutti
and other related patent rights and applications as defined in the agreement.
Under the terms of the agreement, we acquired the exclusive right to develop
any of the claimed inventions, including expandable balloons and related
products, for use within bone, and for use within joints, ligaments, tendons, or
cartilage in the spine and the co-exclusive right to develop any of the claimed
inventions, including expandable balloons and related products, for orthopedic
use in treating or diagnosing injuries of the joints, ligaments, cartilage,
nerves or tendons outside of the spine.  We paid $12.3 million in cash for the
rights, all of which was immediately expensed to purchased in-process research
and development.  At the time of the acquisition, the acquisition cost was
immediately expensed to operations as it was determined that the technology
acquired may be used to develop products that have not been approved for sale by
regulatory authorities, and the in-process projects to which the patents may
apply had not yet reached technological feasibility and had no alternative
future uses.

Other and Interest Income (Expense), Net.  Other and interest
income (expense), net, increased $264,000 in 2004 compared to 2003.  Other and
interest income (expense), net, increased $3.8 million in 2003 compared to 2002.
The increase in 2004 compared to 2003 resulted primarily from an increase in
interest income due to higher cash, cash equivalents and investment balances.
The increase in 2003 from 2002 resulted from interest income from higher cash,
cash equivalent and investment balances resulting from the proceeds of our
initial public offering in May 2002 as well as decreased interest expense from
repaid convertible promissory notes, also in May 2002.

Provision (benefit) for Income Taxes.

At December 31, 2004, we had approximately $14.4 million and $10.0
million in federal and state net operating loss carryforwards, respectively, to
reduce future taxable income.  The federal and state carryforwards have
expiration dates beginning in 2021 and 2007, respectively, in each case if not
utilized.

At December 31, 2004, we had research and development tax credit
carryforwards of approximately $2.2 million and $2.2 million for federal and
state income tax purposes, respectively.  If not utilized, the federal research
and development tax credit carryforwards will expire beginning in 2012.  The
state research and development tax credit can be carried forward indefinitely.

The Tax Reform Act of 1986 limits the use of net operating loss and tax
credit carryforwards in certain situations where changes occur in the stock
ownership of a company.  Ownership changes, as defined, occurred on August 8,
1996, December 14, 1999 and May 17, 2002.  In accordance with Internal Revenue
Code Section 382, utilization of the carryforwards is subject to annual
limitation.  The annual limitation is not expected to result in the expiration
of net operating losses prior to utilization.

Deferred and Stock-Based Compensation

We recorded deferred stock-based compensation for financial reporting
purposes as the difference between the exercise price of options granted to
employees and the deemed fair value of our common stock at the time of grant.
Deferred stock-based compensation is amortized to cost of goods sold, research
and development expense, sales and marketing expense and general and
administrative expense.  Deferred stock-based compensation recorded through
December 31, 2004 was $24.8 million, with accumulated amortization of $22.7
million.  The remaining $2.1 million will be amortized over the remaining
vesting periods of the options.  The options are generally subject to a four-
year total vesting schedule from the date of grant.  All deferred stock-based
compensation amounts are being amortized using a straight-line method.  We
expect to record amortization expense for deferred stock-based compensation as
follows:



|Year | Amount      
|---- | ------------
|2005 | $2.0 million
|2006 | $0.1 million

Stock-based compensation expense related to stock options granted to non-
employees is recognized as the stock options are earned.  The stock-based
compensation expense will fluctuate as the fair market value of our common stock
fluctuates.  In connection with the grant of stock options to non-employees, we
recorded stock-based compensation expense of approximately $929,000, $1.9
million and $1.1 million in 2004, 2003 and 2002, respectively.

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

As of December 31, 2004, we had $87.2 million of cash and cash equivalents,
$28.6 million of investments (short and long-term), and working capital of
$153.9 million.  Our cash and cash equivalents increased during the year ended
December 31, 2004 by $29.7 million over the corresponding amount of cash and
cash equivalents as of December 31, 2003.

Cash Provided by Operating Activities.  Our operating cash flow
in 2004 was primarily the result of our operational profitability.  Net cash
provided by operations was approximately $31.0 million in 2004 attributable
primarily to net income of $21.7 million and adjustments for non-cash charges
related to the amortization of deferred stock-based compensation of $3.9
million, changes in deferred tax assets of $4.1 million and tax benefits from
stock options of $8.7 million.  Accrued liabilities increased by $9.0 million
due to our increased operating expenses and deferred rent and other increased by
$4.2 million.  This was partially offset by increases in inventory balances of
$5.1 million and increases in accounts receivable of $17.6 million as we
increased our net sales.  Net cash provided by operations in 2003 was
approximately $13.0 million primarily attributable to net income of $27.3
million and adjustments for non-cash charges related to the amortization of
deferred stock-based compensation of $6.0 million, increases in accrued
liabilities of $7.0 million and accounts payable of $3.0 million as we accrued
for income taxes and increased our operating expenses offset partially by the
release of the valuation allowance of the deferred tax asset of $21.6 million
and increases in inventory balances of $2.4 million and increases in accounts
receivable of $11.1 million as we increased our net sales.  Our net cash flow
from operations in 2002 reflected a near balance of operational cash inflow
versus growing working capital needs. Net cash provided by operating activities
was $937,000 in 2002 attributable primarily to the add back of $12.3 million
write-off of in-process research and development charge, non-cash charges
related to $6.3 million amortization of deferred stock-based compensation, and
$3.1 million of non-cash interest expense offset partially by net loss of $15.3
million, and increases in accounts receivable and inventories due to increased
sales.

Cash Used in Investing Activities.  Net cash used in investing
activities was $11.2 million, $13.3 million and $39.5 million in 2004, 2003 and
2002, respectively.  Cash used in investing activities reflected purchases of
property and equipment for all periods.  During 2004, cash used in investing
activities reflected the net purchases of investments of $1.6 million.  During
2003, cash used in investing activities reflected the net purchases of
investments of $4.5 million, and payment of $4.9 million in connection with the
Sanatis acquisition.  During 2002, cash used for investing activities reflected
the purchases of investments of $24.7 million and payment of $12.3 million in
connection with the patent sublicense agreement.

Cash Provided by Financing Activities.  Net cash provided by
financing activities was $9.8 million, $6.6 million and $85.0 million in 2004,
2003 and 2002, respectively.  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.  Cash
provided during 2003 was attributable to proceeds from the issuance of common
stock under the employee stock purchase plan of $1.4 million, exercise of stock
options of $2.6 million and repayment of related party notes receivable of $2.5
million.  Cash provided during 2002 was attributable primarily from proceeds of
$94.9 million from issuing common stock in our initial public offering partially
offset by repayment of convertible promissory notes of $13.3 million.

Contractual Cash Obligations.

`Payment Due by Periods
                                            -----------------------------------------------------
                                              Total      2005     2006-2007  2008-2009  After 2009
                                            ---------  ---------  ---------  ---------  ---------
Operating leases                           $  20,428  $   2,260  $   4,292  $   4,328  $   9,548
Asset retirement obligation                      256         --         --         --        256
                                            ---------  ---------  ---------  ---------  ---------
Total commitments                             20,684      2,260      4,292      4,328      9,804
                                            =========  =========  =========  =========  =========`



The amounts reflected in the table above for operating leases represent
aggregate future minimum lease payments and asset retirement obligations under
noncancellable facility leases.  Portions of these payments are denominated in
foreign currencies and were translated in the tables above based on their
respective U.S. dollar exchange rates at December 31, 2004.  These future
payments are subject to foreign currency exchange rate risk.

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

Stock Repurchase.  Our Board of Directors approved a stock
repurchase program on November 7, 2002 pursuant to which up to 2,000,000 shares
of our outstanding common stock may be repurchased.  The duration of the
repurchase program is open-ended.  Under the program, we may purchase shares of
common stock through open market transactions at prices deemed appropriate by
management 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 did not repurchase any of our common stock during
2004 or 2003.

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

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

Recent Accounting Pronouncements

In December 2004, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards ("SFAS") No. 123(R), "Share-
Based Payment" (revised 2004), ("SFAS No. 123(R)").  SFAS No.
123(R) would require companies to measure all stock-based compensation awards
using a fair value method and record such expense in the consolidated financial
statements, including grants of employee stock options.  In addition, the
adoption of SFAS No. 123(R) will require additional accounting related to the
income tax effects and additional disclosure regarding the cash flow effects
resulting from share-based payment arrangements.  SFAS No. 123(R) is effective
for public companies for interim and annual periods beginning after
June 15, 2005.  Adoption of SFAS No. 123(R), which is effective as of July
1, 2005, will have a material adverse impact on our earnings.

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.  Our revenue is derived primarily from the sale
of our 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 and discounts
based upon historical trends and are recorded as a reduction to revenue.

Accounts receivable allowances.  We estimate allowances for doubtful
accounts and for product returns.  Specifically, we make estimates on the
collectibility of customer accounts and sales returns and allowances 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 specific 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, 2004, 2003 and 2002.

Our accounts receivable balance was $42.3 million and
$24.6 million, net of allowances of $1.1 million and $500,000 at December
31, 2004 and 2003, respectively.

Excess and obsolete inventories.  We value our inventory at the lower
of the cost (principally standard cost, which approximates actual cost on a
first-in, first-out basis) or market value.  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 $529,000 and $625,000 at
December 31, 2004 and 2003, respectively.

Accounting for income taxes.  We account for income taxes under the
provisions of SFAS No. 109, "Accounting for Income Taxes."  Under this
method, 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, 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 of December 31, 2002, we had provided a full valuation allowance of $20.4
million against our deferred tax assets, due to uncertainties related to our
ability to utilize our deferred tax assets, primarily consisting of certain net
operating losses carried forward, before they expire.  In the fourth quarter of
2003, we released our valuation allowance because based upon our recurring level
of profitability; we believed that it was more likely than not that we would be
able to utilize our deferred tax assets before they expire.

As part of the process of preparing our consolidated financial statements, we
are required to estimate our income taxes.  This process involves estimating 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 management estimates of taxable
income and the period over which our deferred tax assets would be recoverable.
As of December 31, 2004 and 2003, 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.  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 and have 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 accepted valuation methods.  For
purchased in-process research and development, these methodologies include
consideration of the risk of the project not achieving commercial
feasibility.

Impairment of long-lived assets.  We account for the impairment of
long-lived assets in accordance SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets", or in the case of goodwill,
in accordance with SFAS No. 142, "Goodwill and Other Intangible
Assets".  We evaluate the carrying value of our long-lived assets and
goodwill whenever certain events or changes in circumstances indicate that the
carrying amount of these assets may not be recoverable or at least on an annual
basis for goodwill.  Such events or circumstances include, but are not limited
to, a significant decline in our market value or significant reductions in
projected future cash flows.  The annual goodwill impairment test was completed
in the first quarter of fiscal 2004, and it was determined that there was no
impairment of goodwill at that time.

Significant judgments and assumptions are required in the forecast of future
operating results used in the preparation of 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.

Factors Affecting Future Operating Results

If domestic and international payors adversely change
third party coverage and reimbursement policies for kyphoplasty procedures, or
if reimbursement for kyphoplasty procedures becomes difficult to obtain or is
not available in sufficient amounts, our ability to market and sell our
KyphX instruments would be adversely impacted, which would harm our
business and our future growth.

Our success is dependent
upon the availability of adequate reimbursement within prevailing health care
payment systems in the United States and abroad, for physicians and hospitals
for their services when they perform kyphoplasty procedures using our
KyphX instruments.Medicare currently provides reimbursement at
varying payment levels when kyphoplasty is performed using our KyphX
instruments in all 50 states and in the District of Columbia.  In a small number
of cases, physicians performing a procedure using our instruments have not been
reimbursed, either adequately or at all.  In addition, some physicians in some
states believe that the level of reimbursement they receive is too low.
Reimbursement for competing procedures, such as 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 kyphoplasty procedures using our products are performed.

Medicare, as well as private health maintenance organizations and insurance
plans, may institute adverse changes in payors' policies toward reimbursement of
kyphoplasty procedures.  Medicare and private insurance payors are developing
increasingly sophisticated methods of controlling health care costs through
limitation on reimbursable procedures and the exploration of more cost-effective
methods of delivering health care.  New limits on coverage and reimbursement of
hospitals and other health care providers may significantly impact the
willingness of hospitals, clinics and doctors to purchase and use our
KyphX instruments. Reimbursement and health care payment systems in
international markets vary significantly by country and include both government-
sponsored health care and private insurance. In addition, health care cost
containment efforts similar to those we face in the United States are prevalent
in many of the other countries in which we intend to sell our instruments, and
these efforts are expected to continue in both the United States and abroad.
Future adverse changes in insurance coverage and reimbursement policies in the
United States or other nations would impact our ability to market and sell our
KyphX instruments, harm our business and reduce our revenues.

Currently, Medicare reimburses physicians who use our
KyphX instruments on a state-by-state basis.  This form of reimbursement
is not uniform across all states because there is presently no national CPT
code or associated national payment rate
relating to kyphoplasty procedures using our instruments. In the fourth quarter
of 2004, the AMA CPT Editorial Panel considered
multiple applications for a national CPT code for spine specialist reimbursement
for kyphoplasty, which is the initial step in the CPT process.  We have learned
that the AMA CPT Editorial Panel has decided to support the establishment of a
national CPT code for kyphoplasty.  We also understand that the relative value
survey process involving input from the medical community regarding the
kyphoplasty procedure may begin in the first or second quarter of 2005. We
understand that upon conclusion of the survey process and determination of the
appropriate reimbursement level, the results may be publicly communicated in the
fourth quarter of 2005 in the Federal Register. Despite these developments, we
cannot be certain that a CPT code for kyphoplasty with an associated value ultimately will become
effective in 2006 or at all.  We also cannot assure you that establishment of a
national CPT code, if any, would not adversely affect our business since the
reimbursement level associated with the national CPT code could be less than
what physicians in some states are presently receiving and thus could make
surgery with our products less attractive, which would harm our revenues.Continued adoption of our KyphX instruments by the
medical community may be adversely impacted if physicians perceive they do not
receive sufficient reimbursement from payors for their services in performing
the procedures using our instruments. If
physicians or hospitals are unable to obtain adequate reimbursement for
procedures in which our KyphX instruments are used, we may be unable to
sell our instruments and our business could suffer.

Our 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 orthopedic surgeons and
neurosurgeons, interventional radiologists, and interventional neuroradiologists
the ability treat and restore spinal anatomy during kyphoplasty.  We cannot
assure you that the market for the treatment of spine fractures will continue to
generate significant of consistent demand for our KyphX instruments.
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 approval of,
manufacture and market new products. We must successfully sell and achieve
market acceptance of new products, product extensions and enhanced versions of
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 third-party reimbursement of procedures using
our new products, the existence of competing products and general economic
conditions affecting purchasing patterns. Our ability to market and sell new
products, product extensions and enhanced versions of existing products may also
be subject to government regulation, including clearance/approval by the United
States Food and Drug Administration, or FDA, and foreign government agencies.
Any failure in our ability to successfully develop and introduce new products,
product extensions or enhanced versions of existing products and achieve market
acceptance of new products and product extensions could have a material adverse
effect on our operating results and our business.

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 instruments may decline.

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

- longer-standing distribution networks, and relationships with health care
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; and
- greater resources for product development, sales and marketing and patent
litigation.

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

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

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

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

In April 2004, we filed two patent infringement suits against Disc-O-
Tech.  One has been resolved in our favor; one remains pending. While we believe
our allegations have merit, we cannot assure you that we will prevail in our
suits against Disc-O-Tech.  Regardless of whether we prevail, these suits will
be costly to us and will divert management's attention and resources away from
our business.  If we do not prevail, some or all of our asserted proprietary
rights may be damaged or invalidated, which may harm our valuation and our
ability to protect our business from competition.  In addition, our stock price
may decline as a result of the impact of the litigation, including the financial
impact of the cost of the litigation, public announcements of intermediate
results, the inability or unwillingness of the company to discuss its internal
litigation strategies publicly, and rulings on various motions, and/or the
public's perception of the litigations' progression.

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

The medical device industry has been characterized by
extensive litigation and administrative proceedings regarding patents and other
intellectual property rights. Whether an instrument infringes a patent involves
complex legal and factual issues, the determination of which is often uncertain.
Our competitors may assert that our instruments and methods infringe their
patents. From time to time, we 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/or royalties and/or issue
a preliminary or permanent injunction that would prohibit us from making, using
and selling essential technologies unless we could design around the patents,
which we may be unable to do. Also, although we may seek to obtain a license
under a third party's intellectual property rights to bring an end to any claims
or actions asserted or threatened against us or to address an injunction 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 would do
substantial harm to our business.

If primary care physicians are unwilling or unable to refer a larger
number of patients to trained clinicians that use our products to perform
kyphoplasty, 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 KyphX instruments as an alternative to
conventional spine fracture treatment and conservative pain management
therapies.  In 2003, we initiated a pilot program whereby selected sales
representatives call on primary care physicians to educate them about our
products.  We believe that primary care physicians and spine specialists may not
widely adopt our products unless they determine, based on experience, clinical
data and published, peer-reviewed journal articles, that our products provide
benefits or an attractive alternative to conventional treatments of spine
fractures.  In addition, we believe that recommendations and support of our
products by influential practitioners are essential for market acceptance and
adoption of our products.  If we are unable to convince a significant number of
primary care physicians and spine specialists to accept and use our products,
then our ability to commercialize our KyphX instruments will be negatively
affected, our future growth will be harmed and our business may decline.

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

Our KyphX instruments and bone cement, and our KyphOs calcium
phosphate, 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 do business. Unless an exemption applies, each medical
device that we wish to market in the United States must first receive either
510(k) clearance or premarket approval from the FDA. The FDA's 510(k) clearance
process usually takes from three to 12 months, but may take longer. The
premarket approval process generally takes from one to three years from the time
the application is filed with the FDA, but it can take longer 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 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 kyphoplasty procedures.  These
clearances allow us to promote numerous short- and long-term clinical benefits
associated with kyphoplasty procedures.  Nevertheless, our 510(k) clearances can
be revoked if safety or effectiveness problems develop. We also will be required
to obtain 510(k) clearance or premarket approval to market additional products,
such as new biomaterials for use in kyphoplasty, which will likely require
clinical data, and to market our existing products for new indications, such as
treatment of fractures caused by trauma.  If the clinical data gathered are not
supportive, then applications will not be filed.  If we choose to seek
additional clearances or approvals by filing one or more applications, we cannot
be certain that we would obtain any further 510(k) clearances or premarket
approvals in a timely manner or at all, and delays in obtaining clearances or
approvals may adversely affect our revenue growth and future profitability.

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

In July 2003, the Medicines and Healthcare Products Regulatory Agency
("MHRA") of the United Kingdom issued a Medical Device Alert entitled,
"Injectable polymeric cements in percutaneous vertebroplasty, kyphoplasty
and pedicle screw augmentation procedures."  The United Kingdom MHRA has
received reports of bone cement leaking during vertebroplasty and pedicle screw
augmentation procedures leading to patient complications. The Alert noted that
there have been no complications reported to MHRA from kyphoplasty
procedures, but stated that it was including kyphoplasty procedures in
the Alert due to similarities the MHRA perceived exist between
kyphoplasty procedures and the other procedures it identified in its Alert. We
believe the MHRA's Alert concerning kyphoplasty pertains directly to our
KyphX products, since our products are the only balloons presently
available in Europe to perform kyphoplasty.  The notification asks physicians to
consider alternatives before performing procedures using bone cement in the
spine, to use the manufacturer's instructions in preparing bone cements for use
in the spine, and to take specific precautions before and during those
procedures.  So far, despite the FDA's April 2004 clearance of our bone cement
and other cements for use in kyphoplasty procedures in the United States and the
FDA's subsequent modification of its own Web Notification concerning the use of
bone cement in the spine to acknowledge its clearance of our bone cement, the
MHRA has declined to update its own notification. If the MHRA notification is
not modified or retracted in light of the FDA's clearance of our proprietary
KyphX HV-R Bone Cement for specific use in the spine, then the
notification may raise concerns with our customers, potential customers and
reimbursement organizations, which could negatively impact our ability to sell
and promote our instruments in geographic markets that follow MHRA's guidance.
In addition, an increase in reports of deaths or serious injuries could lead the
FDA or foreign regulatory agencies to issue safety alerts, health advisories, or
mandated labeling changes restricting use of our instruments, including new
warnings regarding their use or contraindicating their use with bone cement,
which could also harm our business and cause our revenues to decline.

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

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

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 adversely affect our operating
results.



We currently manufacture substantially all of our
KyphX instruments in our facilities located in Sunnyvale, California. We
plan to devote significant resources to expand our manufacturing capacity at
this facility. We could experience difficulties and disruptions in the
manufacture of our KyphX instruments. We could also face the inability to
procure and install the necessary manufacturing equipment, a shortage of
components we use in our products, a lack of availability of qualified
manufacturing personnel to work in our Sunnyvale facility, difficulties in achieving
consistent quality control from new manufacturing lines 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.

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

We manufacture medical devices that are used on patients in spine surgery
procedures. Spine surgery, including kyphoplasty, involves risk of serious
complications, including cardiac arrest, cerebrovascular accident, myocardial
infarction, pulmonary embolism, and death. Use of bone filler material by
surgeons to fill the void created using our KyphX Inflatable Bone Tamp
may also lead to these complications, as a result of leakage of the bone filler
material into the spinal canal or surrounding tissue or for other reasons.  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 Europe.  Increased reporting of adverse events in connection with the use
of our or other bone void filler materials during kyphoplasty could expose us to
increased risk of product liability litigation, and our current insurance
coverage limits may not be adequate.  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.

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

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

- 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 of these events could harm our foreign operations.

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

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

- 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.

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

Our world-wide direct sales organization has increased from approximately 31
employees in October 2000 to over 350 employees in December 2004, which we
believe represents very 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 700 employees in December 2004.  We intend
to continue to grow 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 attract and retain other qualified personnel or
advisors could have a material adverse effect on or results of operations and
financial condition.

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 the larger countries in Europe and in Canada,
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 recently
terminated our relationship with distributors in Mexico and Korea and are in the
process of establishing new relationships in those geographic regions.  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.

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 have a material adverse effect on us. We could
incur material expenses in the future realting 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.

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

We may acquire companies, products or technologies that we believe to be
complementary to our present or future direction of our business.  We do not
know if we will be able to successfully complete any future acquisitions.  If we
do so, we may have difficulty integrating the acquired personnel, financials,
operations, products or technologies. Acquisitions may dilute our earnings per
share, disrupt our ongoing business, distract our management and employees and
increase our expenses, which could harm our business.

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

Our officers, directors and principal stockholders together control
approximately 39% of our outstanding common stock as of February 15, 2005. If
these stockholders act together, they will be able to control our management and
affairs in all matters requiring stockholder approval, including the election of
directors and approval of significant corporate transactions. This concentration
of ownership may adversely affect the market price of our common stock. This
concentration of ownership may not be in the best interests of our other
stockholders.  In addition, our other stockholders may not perceive that one or
more actions taken by this concentrated group of stockholders is in our or the
remaining stockholders' best interests, which could harm our valuation and our
stock price may decline.

Our certificate of incorporation and by-laws include 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.

Recently enacted and proposed changes in securities and corporate governance
laws and regulations will increase our costs.

The Sarbanes-Oxley Act of 2002 that became law in July 2002, as well as new
rules and regulations subsequently implemented by the SEC and the NASDAQ
exchange on which we are listed, have required changes to some of our corporate
governance practices. The Act also requires the SEC to promulgate additional new
rules on a variety of subjects. We expect all of these new rules and regulations
to increase our legal and financial compliance costs, to make some activities
more difficult, time consuming and/or costly, and to make it more difficult and
more expensive for us to obtain director and officer 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 can provide no assurance regarding our, or our independent auditor's,
conclusions after December 31, 2004 with respect to the effectiveness of our
internal controls 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 for
the years ending on and after December 31, 2004. 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 are expending significant resources in developing the necessary
documentation and testing procedures required by Section 404, given the risks
inherent in the design and operation of internal controls over financial
reporting, we can provide no assurance as to our, or our independent auditor's,
conclusions after December 31, 2004 with respect to the effectiveness of our
internal controls over financial reporting. If we are unable to comply 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, 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.

Recent changes in the required accounting treatment for stock options will
have a material negative impact on our financial statements and may affect our
stock price.

In December 2004, the Financial Accounting Standards
Board issued SFAS No. 123(R),
pursuant to which we must measure all stock-based compensation awards, including
grants of employee stock options, using a fair value method and record such
expense in our consolidated financial statements.  This requirement to
expense stock-based compensation awards is set to take effect for public
companies for interim and annual periods beginning after June 15,
2005.  Currently, Kyphon discloses such expenses on a pro forma basis in
the notes to our annual financial statements, but does not record a charge for
employee stock option expensein the reported financial
statements. Once Kyphon begins to comply with SFAS No. 123(R) as of the
beginning of the third quarter of 2005, our reported earnings will decrease,
which may affect our stock price.

ITEM 7A.   QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

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

We have operated mainly in the United States, and 88%, 90%, and 93% of our
sales were made in U.S. dollars in 2004, 2003, and 2002, respectively.  The
majority of our European 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 Statement of
Operations, as applicable.

ITEM 8.	CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA





MANAGEMENT'S RESPONSIBILITY FOR FINANCIAL INFORMATION

We are responsible for the preparation and integrity of the consolidated
financial statements appearing in our Annual Report.  The consolidated financial
statements were prepared in conformity with United States generally accepted
accounting principles and include amounts based on management's estimates and
judgments.  All other financial information in this report has been presented on
a basis consistent with the information included in the financial
statements.

Our control environment is the foundation for our system of internal controls
over financial reporting and is embodied in our Code of Business Conduct and
Ethics.  It sets the tone of our organization and includes factors such as
integrity and ethical values.  Our internal controls over financial reporting
are supported by formal policies and procedures which are reviewed, modified and
improved as changes occur in business conditions and operations.

The Audit Committee of the Board of Directors, which is composed solely of
outside directors, meets periodically with members of management and the
independent registered public accounting firm to review and discuss internal
controls over financial reporting and accounting and financial reporting
matters.  The independent registered public accounting firm reports to the Audit
Committee and accordingly has full and free access to the Audit Committee at any
time.

MANAGEMENT'S REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING

We are also responsible for establishing and maintaining adequate internal
control over financial reporting.  We maintain a system of internal controls
that is designed to provide reasonable assurance as to the fair and reliable
preparation and presentation of the consolidated financial statements, as well
as to safeguard our assets from unauthorized use or disposition.

We conducted an evaluation of the effectiveness of our internal controls over
financial reporting based on the framework in Internal Control - Integrated
Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission.  This evaluation included review of the documentation of
controls, evaluation of the design effectiveness of controls, testing of the
operating effectiveness of the controls and a conclusion on this evaluation.
Because of its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements.  Also, projections of any evaluation of the 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 deterio.  Based on our evaluation , we have concluded
that our internal control over financial reporting was effective as of December 31, 2004.

PricewaterhouseCoopers LLP, an independent registered public accounting firm, has audited management's assessment
of the effectiveness of internal control over financial reporting as of December 31, 2004 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
Statements of Operations for the years ended December 31, 2004, 2003 and
2002                    
|Consolidated Balance
Sheets at December 31, 2004 and 2003                                                     
|Consolidated
Statements of Cash Flows for the years ended December 31, 2004, 2003 and
2002                    
|Consolidated
Statements of Stockholder's Equity (Deficit) for the years ended December
31, 2004, 2003 and 2002
|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 an integrated audit of Kyphon Inc.'s 2004
consolidated financial statements and of its internal control over financial
reporting as of December 31, 2004 and audits of its 2003 and 2002
consolidated financial statements 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, 2004 and 2003, and the results
of their operations and their cash flows for each of the three years in the
period ended December 31, 2004 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.

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, 2004 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, 2004, 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 
March 2, 2005

---



KYPHON INC..
                     CONSOLIDATED STATEMENTS OF OPERATIONS 
                    (in thousands, except share and per share amounts)

`Year Ended December 31,
                                                     ----------------------------------
                                                        2004        2003        2002
                                                     ----------  ----------  ----------
Net sales                                           $  213,414  $  131,028  $   76,316
Cost of goods sold                                      24,734      16,794      10,416
                                                     ----------  ----------  ----------

Gross profit                                           188,680     114,234      65,900
                                                     ----------  ----------  ----------

Operating expenses:
  Research and development                              22,043      15,237      10,145
  Sales and marketing                                  104,299      68,676      43,509
  General and administrative                            27,971      17,348      12,540
  Purchased in-process research and development             --         636      12,250
                                                     ----------  ----------  ----------
      Total operating expenses                         154,313     101,897      78,444
                                                     ----------  ----------  ----------

Income (loss) from operations                           34,367      12,337     (12,544)

Interest income                                          1,314       1,067         929
Interest expense                                            --         (23)     (3,672)
Other expense, net                                         (64)        (58)        (51)
                                                     ----------  ----------  ----------

Net income (loss) before income taxes                   35,617      13,323     (15,338)
Provision (benefit) for income taxes                    13,900     (14,000)         --
                                                     ----------  ----------  ----------
Net income (loss)                                   $   21,717  $   27,323  $  (15,338)
                                                     ==========  ==========  ==========

Net income (loss) per share:
  Basic                                             $     0.54  $     0.71  $    (0.63)
                                                     ==========  ==========  ==========
  Diluted                                           $     0.50  $     0.65  $    (0.63)
                                                     ==========  ==========  ==========

Weighted-average shares outstanding:
  Basic                                                 40,449      38,433      24,405
                                                     ==========  ==========  ==========
  Diluted                                               43,670      42,090      24,405
                                                     ==========  ==========  ==========`

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

---



KYPHON INC.
                           CONSOLIDATED BALANCE SHEETS
                    (in thousands, except share and per share amounts)

`December 31,
                                                                      ----------------------
                                                                         2004        2003
                                                                      ----------  ----------
Assets                                                                                      
Current assets:
  Cash and cash equivalents                                          $   87,236  $   57,494
  Investments                                                            24,421      13,456
  Accounts receivable, net of allowances of $1,054 in 2004
    and $500 in 2003                                                     42,347      24,632
  Inventories                                                            11,457       6,239
  Prepaid expenses and other current assets                               4,521       3,810
  Deferred tax assets                                                    13,537       1,163
                                                                      ----------  ----------
      Total current assets                                              183,519     106,794

Investments                                                               4,142      14,529
Property and equipment, net                                              12,728       6,044
Goodwill and other intangible assets, less accumulated
   amortization of $65 in 2004 and $26 in 2003                            5,039       4,722
Deferred tax assets                                                       4,009      20,462
Other assets                                                              3,952       1,929
                                                                      ----------  ----------

      Total assets                                                   $  213,389  $  154,480
                                                                      ==========  ==========

Liabilities and Stockholders' Equity                                                        
Current liabilities:
  Accounts payable                                                   $    5,544  $    5,531
  Accrued liabilities                                                    24,049      14,699
                                                                      ----------  ----------
      Total current liabilities                                          29,593      20,230
                                                                      ----------  ----------

Deferred rent and other                                                   4,161          --
                                                                      ----------  ----------
      Total liabilities                                                  33,754      20,230
                                                                      ----------  ----------

Commitments and contingencies (Note 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: 41,355 shares in 2004 and 39,470 shares in 2003
    Outstanding: 41,325 shares in 2004 and 39,440 shares in 2003             41          39
  Additional paid-in capital                                            189,410     171,359
  Treasury stock, at cost: 30 shares in 2004 and 2003                      (201)       (201)
  Deferred stock-based compensation, net                                 (2,113)     (6,435)
  Accumulated other comprehensive income                                  3,489       2,196
  Accumulated deficit                                                   (10,991)    (32,708)
                                                                      ----------  ----------
      Total stockholders' equity                                        179,635     134,250
                                                                      ----------  ----------

        Total liabilities and stockholders' equity                   $  213,389  $  154,480
                                                                      ==========  ==========`

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,
                                                                                  -------------------------------
                                                                                    2004       2003       2002
                                                                                  ---------  ---------  ---------
Cash flows from operating activities:                                                                            
  Net income (loss)                                                              $  21,717  $  27,323  $ (15,338)
  Adjustments to reconcile net income (loss) to net cash provided by
    operating activities:
      Provision for accounts receivable allowances                                     737        404          3
      Provision for excess and obsolete inventories                                    158        550        470
      Depreciation and amortization                                                  2,817      2,237      1,298
      Deferred tax assets                                                            4,080    (21,625)        --
      Tax benefit from stock options                                                 8,741      3,496         --
      Loss on disposal of property and equipment                                        93         47         60
      Non-cash interest expense                                                         --         --      3,081
      Amortization of deferred stock-based compensation                              3,852      5,966      6,328
      Write-off of in-process research and development                                  --        636     12,250
      Changes in operating assets and liabilities, net of effect of acquisition:
        Accounts receivable                                                        (17,581)   (11,086)    (8,358)
        Inventories                                                                 (5,127)    (2,373)    (2,493)
        Prepaid expenses and other current assets                                      343     (1,452)    (1,739)
        Other assets                                                                (1,975)    (1,182)     1,100
        Accounts payable                                                               (40)     3,013        518
        Accrued liabilities                                                          9,030      7,031      3,757
        Deferred rent and other                                                      4,156         --         --
                                                                                  ---------  ---------  ---------
            Net cash provided by operating activities                               31,001     12,985        937
                                                                                  ---------  ---------  ---------

Cash flows from investing activities:                                                                            
  Acquisition of property and equipment                                             (9,650)    (3,961)    (2,571)
  Proceeds from disposal of property and equipment                                      --         --         20
  Maturities and sales of investments                                               19,945     30,023         --
  Purchases of investments                                                         (21,523)   (34,537)   (24,663)
  Payment for acquisition                                                               --     (4,850)   (12,250)
                                                                                  ---------  ---------  ---------
            Net cash used in investing activities                                  (11,228)   (13,325)   (39,464)
                                                                                  ---------  ---------  ---------

Cash flows from financing activities:                                                                            
  Proceeds from issuance of common stock, net                                        3,421      1,417     94,925
  Repurchase of common stock                                                            --         --        (23)
  Proceeds from exercise of warrants                                                    --         --         77
  Proceeds from exercise of stock options                                            6,361      2,640      1,254
  Proceeds from payment of related party note receivable                                --      2,510        379
  Acquisition of treasury stock                                                         --         --       (201)
  Proceeds from convertible promissory notes                                            --         --      2,000
  Repayment of convertible promissory notes                                             --         --    (13,300)
  Repayment of notes payable                                                            --         --       (159)
                                                                                  ---------  ---------  ---------
            Net cash provided by financing activities                                9,782      6,567     84,952
                                                                                  ---------  ---------  ---------
Effect of foreign exchange rate changes on cash                                        187      1,400         90
                                                                                  ---------  ---------  ---------
Net increase in cash and cash equivalents                                           29,742      7,627     46,515

Cash and cash equivalents at beginning of year                                      57,494     49,867      3,352
                                                                                  ---------  ---------  ---------
Cash and cash equivalents at end of year                                         $  87,236  $  57,494  $  49,867
                                                                                  =========  =========  =========

Supplementary disclosure of noncash financing activities:                                                        
  Deferred stock-based compensation, net of cancellations                        $    (470) $     454  $   2,193
                                                                                  =========  =========  =========
  Issuance of warrants                                                           $      --  $      --  $   1,540
                                                                                  =========  =========  =========
  Conversion of redeemable convertible preferred stock to common stock           $      --  $      --  $  38,024
                                                                                  =========  =========  =========
Supplemental disclosure of cash flow information:                                                                
  Cash paid during the year for interest                                         $      --  $      23  $     854
                                                                                  =========  =========  =========
  Cash paid during the year for income taxes                                     $     400  $      43  $      --
                                                                                  =========  =========  =========`

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

---



KYPHON INC.
       CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                      (in thousands)

`Accumulated
                                                                       Common Stock     Additional                Deferred         Other                         Total
                                                                    ------------------   Paid-In     Treasury   Stock-Based    Comprehensive   Accumulated   Shareholders'
                                                                     Shares    Amount    Capital      Stock     Compensation   Income (Loss)     Deficit    Equity (Deficit)
                                                                    --------  --------  ----------  ----------  ------------  ---------------  -----------  ---------------
Balance at January 1, 2002                                            2,330  $      2  $   23,122  $       --  $    (16,082) $           (16) $   (44,693) $       (37,667)
Exercise of stock options                                             1,742         2       1,252          --            --               --           --            1,254
Repurchase of common stock                                              (30)       --         (23)         --            --               --           --              (23)
Issuance of common stock upon filing of initial public
  offering, net of issuance costs of $1,330                           6,900         7      94,918          --            --               --           --           94,925
Conversion of redeemable convertible preferred stock                 26,291        26      37,998          --            --               --           --           38,024
Issuance of common stock upon exercise of warrants                       78        --          77          --            --               --           --               77
Conversion of promissory note                                            49        --         736          --            --               --           --              736
Warrants issued in connection with promissory note                       --        --       1,540          --            --               --           --            1,540
Beneficial conversion feature associated with promissory notes           --        --       1,541          --            --               --           --            1,541
Acquisition of treasury stock                                           (30)       --          --        (201)           --               --           --             (201)
Cumulative translation adjustments                                       --        --          --          --            --              252           --              252
Unrealized gain on available-for-sale investments, net of tax            --        --          --          --            --               66           --               66
Deferred stock-based compensation, net of cancellations                  --        --       2,193          --        (2,193)              --           --               --
Amortization of deferred stock-based compensation                        --        --          --          --         6,328               --           --            6,328
Net loss                                                                                                                                          (15,338)         (15,338)
                                                                    --------  --------  ----------  ----------  ------------  ---------------  -----------  ---------------
Balance at December 31, 2002                                         37,330        37     163,354        (201)      (11,947)             302      (60,031)          91,514
Exercise of stock options                                             1,875         2       2,638          --            --               --           --            2,640
Issuance of common stock under employee stock purchase plan             176        --       1,417          --            --               --           --            1,417
Issuance of common stock upon exercise of warrants                       59        --          --          --            --               --           --               --
Tax benefits from exercise of common stock options                       --        --       3,496          --            --               --           --            3,496
Cumulative translation adjustments                                       --        --          --          --            --            1,934           --            1,934
Unrealized gains (losses) on available-for sale investments              --        --          --          --            --              (40)          --              (40)
Deferred stock-based compensation, net of cancellations                  --        --         454          --          (454)              --           --               --
Amortization of deferred stock-based compensation                        --        --          --          --         5,966               --           --            5,966
Net income                                                                                                                                         27,323           27,323
                                                                    --------  --------  ----------  ----------  ------------  ---------------  -----------  ---------------
Balance at December 31, 2003                                         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
Cumulative translation adjustments                                       --        --          --          --            --            1,366           --            1,366
Unrealized gains (losses) on available-for sale investments              --        --          --          --            --              (73)          --              (73)
Deferred stock-based compensation, net of cancellations                  --        --        (470)         --           470                            --               --
Amortization of deferred stock-based compensation                        --        --          --          --         3,852               --           --            3,852
Net income                                                                                                                                         21,717           21,717
                                                                    --------  --------  ----------  ----------  ------------  ---------------  -----------  ---------------
Balance at December 31, 2004                                         41,325  $     41  $  189,410  $     (201) $     (2,113) $         3,489  $   (10,991) $       179,635
                                                                    ========  ========  ==========  ==========  ============  ===============  ===========  ===============`

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 for surgeons and their patients for the restoration
of spinal anatomy.  The Company is currently commercializing surgical tools that
use its proprietary balloon technologies for the repair of spinal fractures.
The Company markets its products through sales representatives in the United
States, and through a combination of sales representatives, distributors and
agents in its international markets.  The Company is headquartered in Sunnyvale,
California.

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 as necessary.  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 a separate component
of stockholders' equity (deficit), or to the Statement of Operations, as
applicable.

Use of Estimates

In accordance with accounting principles generally accepted in the United
States of America, management utilizes certain estimates and assumptions that
affect the reported amounts of assets and liabilities at the date of the
financial statements and the reported amounts of revenues and expenses during
the reporting period.  The primary estimates underlying the Company's financial
statements include the allowance for doubtful accounts receivable, allowance for
sales returns, reserves for obsolete and slow moving inventory, asset retirement
obligations, income taxes and accrual for other liabilities.  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, certificates of deposit, and commercial
paper.

Restricted Cash

Under the terms of its facility lease, the Company issued an irrevocable
standby letter of credit of $1,000,000 to the lessor for the term of the
facility lease.  The letter of credit is secured by a certificate of deposit of
$1,000,000 which was classified as other assets as of December 31, 2004 and
2003.

Investments

All 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 (deficit).  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 year ended December 31, 2004, 2003 and 2002.  The
Company's available-for-sale investments are summarized as follows (in
thousands):

`December 31, 2004                                               Gross      Gross
                                                   Amortized  Unrealized Unrealized   Fair
                                                     Cost       Gains     Losses      Value
                                                   ---------  ---------  ---------  ---------
Money market funds                                $  79,342  $      --  $      --  $  79,342
Corporate notes and bonds                            28,646         --        (83)    28,563
                                                   ---------  ---------  ---------  ---------
Total                                             $ 107,988  $      --  $     (83) $ 107,905
                                                   =========  =========  =========  =========

Reported as:
Cash equivalents                                                                   $  79,342
Short-term investments                                                                24,421
Long-term investments                                                                  4,142
                                                                                    ---------
Total                                                                              $ 107,905
                                                                                    =========


December 31, 2003                                               Gross      Gross
                                                   Amortized  Unrealized Unrealized   Fair
                                                     Cost       Gains     Losses      Value
                                                   ---------  ---------  ---------  ---------
Money market funds                                $  49,779  $      --  $      --  $  49,779
Corporate notes and bonds                            27,959         28         (2)    27,985
                                                   ---------  ---------  ---------  ---------
Total                                             $  77,738  $      28  $      (2) $  77,764
                                                   =========  =========  =========  =========

Reported as:
Cash equivalents                                                                   $  49,779
Short-term investments                                                                13,456
Long-term investments                                                                 14,529
                                                                                    ---------
Total                                                                              $  77,764
                                                                                    =========`





The following table summarizes the maturities of the Company's investments as
of December 31, 2004 (in thousands):

`Corporate notes and bonds:
Maturities of one year or less                              $  24,421
Maturities between one and two years                            4,142

Money market funds:
Original maturities of three months or less                    79,342
                                                             ---------
Total                                                       $ 107,905
                                                             =========`



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 and sales returns and allowances based primarily on 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 specific
allowances are reevaluated and adjusted as additional information is received
that impacts the amount reserved.

Inventories

Inventories are stated at the lower of cost (principally standard cost, which
approximates actual cost on a first-in, first-out basis) or market value.
Inventory costs include direct materials, direct labor, direct subcontract
costs, and manufacturing overhead.  Reserves for potentially excess and obsolete
inventory are made based on management's analysis of inventory levels and future
sales forecasts.

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 one 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 expense, net.  Repairs and maintenance expenses are charged to the
Statement of Operations as incurred.

Asset Retirement Obligation

The Company accounts for the retirement of tangible long-lived assets and
the associated asset retirement costs in accordance with Statement of Financial
Accounting Standards ("SFAS") No. 143, "Accounting for Asset
Retirement Obligations".  SFAS No. 143 requires that the fair value of a
liability for an asset retirement obligation be recognized in the period in
which it is incurred if a reasonable estimate of fair value can be made.  In
accordance with SFAS No. 143, the fair value of the liability 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 obligation
is associated with its commitment to return property subject to an operating
lease in Brussels, Belgium to original condition upon lease termination.  The
Company estimated that as of December 31, 2004, gross expected future cash flows
of approximately $404,000 would be required to fulfill these obligations.

The Company has recorded an asset retirement obligation of approximately
$256,000 and a corresponding increase in leasehold improvements.  This amount
represents the present value of expected future cash flows associated with
returning the leased property to original condition.  This amount is subject to
foreign exchange rate fluctuations and has been translated using the exchange
rate at December 31, 2004.  The leasehold improvements are being amortized to
depreciation expense over the term of the lease.  During the year ended December
31, 2004, approximately $39,000 of the leasehold improvements were amortized to
expense.

Goodwill and Other Intangible Assets

SFAS No. 142, "Goodwill and Other Intangible Assets" requires
goodwill to be tested for impairment on an annual basis and between annual tests
in certain circumstances, and written down when impaired. Furthermore, SFAS No.
142 requires purchased intangible assets other than goodwill to be amortized
over their useful lives unless these lives are determined to be indefinite.

The Company is amortizing its intangible assets on a straight
line basis over a five year period.  No amortization of goodwill has been
recorded.  Instead, the Company performs an impairment assessment by applying a
fair-value based test in the first quarter of each year, or more frequently if
changes in circumstances or the occurrence of events suggest the remaining value
is not recoverable.  The annual goodwill impairment analysis was completed in
the first quarter of 2004, and it was determined that there was no impairment of
goodwill at that time.

Impairment of Long-Lived Assets

Pursuant to SFAS No. 144, "Accounting for the Impairment or Disposal of
Long-Lived Assets," the Company periodically assesses whether long-lived
assets have been impaired.  An asset is deemed to be impaired if its estimated
future undiscounted cash flows are less than the carrying value recorded on the
Company's balance sheet.  The Company's estimate of fair value is based on the
net present value of expected future cash flows attributable to the asset.
Predicting future cash flows attributable to a particular asset is difficult,
and requires the use of significant judgment.

Concentrations of Credit Risk and Other Risks and Uncertainties

The Company's cash and cash equivalents are deposited with two major
financial institutions in the United States of America and in some major
European cities, Canada and Japan.  Deposits in those institutions may exceed
the amount of insurance provided on such deposits.

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's accounts receivable are derived from net sales earned from
customers located in the United States of America and Europe.  The Company
performs ongoing credit evaluations of its customers' financial condition and,
generally, requires no collateral from its customers.  As of December 31, 2004,
71% and 29%, respectively, of accounts receivable were from United States of
America and Europe.

As of December 31, 2003, 73% and 27%, respectively, of accounts receivable
were from United States of America and Europe.

No customer accounted for more than 10% of total net sales for the year ended
December 31, 2004, 2003 and 2002.  No customer accounted for more than 10% of
total accounts receivable at December 31, 2004, and 2003.

The Company's current line of products is limited to devices and bone filler
biomaterials used in the repair of compression fractures of the spine caused
primarily by osteoporosis and cancer.  Some of the Company's products require
clearance or approval from the United States Food and Drug Administration
("FDA") prior to the commencement of commercialized sales.  In July 1998, the
Company received initial FDA clearance for its KyphX Inflatable Bone
Tamp.  In February 2001, the Company received an additional 510(k) clearance
that clarified that the KyphX Inflatable Bone Tamp is intended for use in
the spine, hand, tibia, radius and calcaneus.  In April 2004, the Company
received 510(k) clearance from the FDA to market KyphX HV-R Bone Cement.
Internationally, the Company received CE Mark approval to market its products
from the European regulatory agency in April 2000.  The Company cannot be
assured that future products will receive the necessary approvals or clearances.
If the Company is denied approval or clearance or if approval or clearance is
delayed, this may have a material adverse impact on the Company.

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 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 are
included in net sales and were approximately $766,000 and $400,000 for the year
ended December 31, 2004 and 2003, respectively.  Prior to 2003, such amounts
were insignificant and were classified as an offset to cost of goods sold.
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 $3,515,000, $3,552,000 and
$1,873,000 for the year ended December 31, 2004, 2003 and 2002, respectively.

Income Taxes

The Company accounts for income taxes under the 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 expected
to be realized.

Segments

The Company operates in one segment, using one measurement of profitability
to manage its business.  As of December 31, 2004 and 2003, 83% and 87%,
respectively, of all long-lived assets were maintained in the United States of
America.  For the year ended December 31, 2004, 2003 and 2002, 88%, 90% and 93%,
respectively, of net sales were generated in the United States of America.

Comprehensive Income (Loss)

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

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

`Year Ended December 31,
                                                                        -------------------------------
                                                                          2004       2003       2002
                                                                        ---------  ---------  ---------
Net income (loss)                                                      $  21,717  $  27,323  $ (15,338)

Changes in unrealized gains (losses) on available-for-sale
    investments, net of taxes                                                (73)       (40)        66
Translation adjustments                                                    1,366      1,934        252
                                                                        ---------  ---------  ---------
Total comprehensive income (loss)                                      $  23,010  $  29,217  $ (15,020)
                                                                        =========  =========  =========`





The components of comprehensive income (loss), net of taxes reflected in the
consolidated statements of stockholders' equity (deficit) are as follows (in
thousands):

`December 31,
                                                              --------------------
                                                                2004       2003
                                                              ---------  ---------
Unrealized gains (losses) on available-for-sale
    investments, net of taxes                                $     (47) $      26
Translation adjustments                                          3,536      2,170
                                                              ---------  ---------
                                                             $   3,489  $   2,196
                                                              =========  =========`





Net Income (Loss) per Share

Basic net income (loss) per share is computed by dividing net income (loss)
by the weighted-average number of common shares outstanding for the period.
Diluted net income (loss) per share is computed giving effect to all potential
dilutive common stock, including options, warrants, common stock subject to
repurchase, convertible promissory notes and redeemable convertible preferred
stock.  For the year ended December 31, 2004, 2003 and 2002, certain options,
common stock subject to a right of repurchase and warrants were not included in
the computation of diluted net income (loss) per share for the Company because
the effect would be antidilutive.

A reconciliation of the numerator and denominator used in the calculation
of basic and diluted net income (loss) per share follows (in thousands, except
per share amounts):

`Year Ended December 31,
                                                                        -------------------------------
                                                                          2004       2003       2002
                                                                        ---------  ---------  ---------
Net income (loss)                                                      $  21,717  $  27,323  $ (15,338)
                                                                        =========  =========  =========

Weighted-average shares outstanding                                       40,451     38,461     24,514
  Less: weighted-average shares subject to repurchase                         (2)       (28)      (109)
                                                                        ---------  ---------  ---------
Basic weighted-average shares outstanding                                 40,449     38,433     24,405
                                                                        =========  =========  =========

Dilutive effect of:
  Options to purchase common stock                                         3,218      3,610         --
  Warrants                                                                     3         47         --
                                                                        ---------  ---------  ---------
Diluted weighted-average shares outstanding                               43,670     42,090     24,405
                                                                        =========  =========  =========

Net income (loss) per share:
  Basic                                                                $    0.54  $    0.71  $   (0.63)
                                                                        =========  =========  =========
  Diluted                                                              $    0.50  $    0.65  $   (0.63)
                                                                        =========  =========  =========`



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

`December 31,
                                                                        -------------------------------
                                                                          2004       2003       2002
                                                                        ---------  ---------  ---------

Options to purchase common stock                                             509        146      6,826
Common stock subject to repurchase                                            --         13         34
Warrants                                                                      --         --         64`



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, 2004 and 2003, the
Company held 30,000 shares of treasury stock.  Treasury stock is accounted for
using the cost method.

Accounting for Stock-Based Compensation

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

The following table, assuming a 40% effective tax rate in 2004 and 2003,
provides a reconciliation of net income (loss) and net income (loss) per share
to pro forma net income (loss) and pro forma net income (loss) per share had
compensation cost for the Company's stock option grants to employees been
determined based on the fair value of each option on the date of grant
consistent with the methodology prescribed by SFAS No. 123 (in thousands, except
per share amounts):

`Year Ended December 31,
                                                                        -------------------------------
                                                                          2004       2003       2002
                                                                        ---------  ---------  ---------
Net income (loss), as reported                                         $  21,717  $  27,323  $ (15,338)
Add:  Stock-based employee compensation expense included in
  reported net income (loss), net of taxes                                 1,754      2,447      5,183
Deduct:  Total stock-based employee compensation expense,
  determined under fair value based method for all awards, net of taxes   (9,735)    (6,291)    (6,625)
                                                                        ---------  ---------  ---------

Pro forma net income (loss)                                            $  13,736  $  23,479  $ (16,780)
                                                                        =========  =========  =========

Net income (loss) per share
Basic:
  As reported                                                          $    0.54  $    0.71  $   (0.63)
                                                                        =========  =========  =========
  Pro forma                                                            $    0.34  $    0.61  $   (0.69)
                                                                        =========  =========  =========
Diluted:
  As reported                                                          $    0.50  $    0.65  $   (0.63)
                                                                        =========  =========  =========
  Pro forma                                                            $    0.31  $    0.56  $   (0.69)
                                                                        =========  =========  =========`



The weighted-average assumptions used are as follows:

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

                                     Employee Stock Options
                               -------------------------------
                                 2004       2003       2002
                               ---------  ---------  --------- 
Risk-free interest rate            3.04%      2.58%      3.59%
Expected volatility                  62%        70%        76%
Expected life (in years)              4          4          4
Dividend yield                       --         --         --


                                 Employee Stock Purchase Plan
                               -------------------------------
                                 2004       2003       2002
                               ---------  ---------  ---------  
Risk-free interest rate            1.22%      1.15%      1.21%
Expected volatility                  66%        66%        71%
Expected life (in years)           1.52       0.74       1.52
Dividend yield                       --         --         --`



The weighted-average grant date fair value per share of options granted
during the year ended December 31, 2004, 2003 and 2002 was $12.61, $8.84 and
$4.89, respectively.  The weighted average fair value for shares purchased
through the employee stock purchase plan during the years ended December 31,
2004 and 2003 were $6.80 and $3.96 per share, respectively.  No shares were
purchased under the employee stock purchase plan during the year ended December
31, 2002.

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

Deferred and Stock-Based Compensation

The Company has issued to certain employees options under the 1996 Plan and
shares of common stock under stock purchase agreements, some of which contained
repurchase provisions, with exercise prices below the deemed fair market value
of the Company's common stock at the date of grant.  The Company's right to
repurchase shares of restricted common stock lapsed as these shares became
vested to the employee.  In accordance with the requirements of APB No. 25, the
Company has recorded deferred stock-based compensation for the difference
between the exercise price of the stock options or restricted common stock and
the deemed fair market value of the Company's stock at the date of grant.  This
deferred stock-based compensation is amortized to expense on a straight line
basis, over the period during which the Company's right to repurchase the
restricted common stock lapses or the options become exercisable, generally four
years.

Stock-based compensation expense related to stock options granted to non-
employees is recognized as the stock options are earned.  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, and the
vested portion of these options were remeasured at each vesting date.  The
Company believes that the fair value of the stock options is more reliably
measurable than the fair value of the services received.  The fair value of the
stock options granted were revalued at each reporting date using the Black-
Scholes option pricing model as prescribed by SFAS No. 123 using the following
weighted-average assumptions:

`Year Ended December 31,
                                   -------------------------------
                                     2004       2003       2002
                                   ---------  ---------  ---------
Risk-free interest rate                4.21%      3.92%      4.45%
Expected volatility                      65%        74%        76%
Expected life (in years)                 10         10         10
Dividend yield                           --         --         --`





The Company recognized stock-based compensation expense related to employee
and non-employee options as follows (in thousands):

`Year Ended December 31,
                                   -------------------------------
                                     2004       2003       2002
                                   ---------  ---------  ---------
Cost of goods sold                $     317  $     467  $     587
Research and development              1,134      2,232      1,906
Sales and marketing                   1,360      2,012      2,243
General and administrative            1,041      1,255      1,592
                                   ---------  ---------  ---------
                                  $   3,852  $   5,966  $   6,328
                                   =========  =========  =========`





Reclassification

Certain amounts in the prior year consolidated financial statements have
been reclassified to conform to the current year's presentation.  The
reclassification had no impact on the previously reported net income (loss).

Recent Accounting Pronouncements

In December 2004, the Financial Accounting Standards Board issued SFAS No.
123(R), "Share-Based Payment" (revised 2004), ("SFAS No.
123(R)").  SFAS No. 123(R) will require companies to measure all stock-
based compensation awards using a fair value method and record such expense in
the consolidated financial statements, including grants of employee stock
options.  In addition, the adoption of SFAS No. 123(R) will require additional
accounting related to the income tax effects and additional disclosure regarding
the cash flow effects resulting from share-based payment arrangements.  SFAS No.
123(R) is effective for public companies for interim and annual periods
beginning after June 15, 2005.  The adoption of SFAS No. 123(R), which is
effective as of July 1, 2005, will decrease the Company's earnings.

3. BALANCE SHEET COMPONENTS

Inventories (in thousands):

`December 31,
                                                    --------------------
                                                      2004       2003
                                                    ---------  ---------
Raw materials                                      $   5,715  $   3,327
Work-in-process                                        1,042        647
Finished goods                                         4,700      2,265
                                                    ---------  ---------
                                                   $  11,457  $   6,239
                                                    =========  =========`





Property and Equipment (in thousands):

`December 31,
                                                    --------------------
                                                      2004       2003
                                                    ---------  ---------
Furniture and fixtures                             $   2,752  $   1,284
Computer software and hardware                         4,929      3,455
Laboratory and manufacturing equipment                 4,695      3,585
Leasehold improvements                                 5,943        965
                                                    ---------  ---------
                                                      18,319      9,289
Less:  Accumulated depreciation and amortization      (6,158)    (4,474)
Plus:  Construction-in-progress                          567      1,229
                                                    ---------  ---------
                                                   $  12,728  $   6,044
                                                    =========  =========`



Goodwill and Intangible Assets:

Changes in the carrying amount of goodwill and the intangible assets
occurring during the year ended December 31, 2004 and 2003 are as follows
(in thousands):

`2004      2003
                                                    ---------  ---------

Goodwill at beginning of the year                   $    4,584  $       --
Goodwill acquired during the year                           --       4,072
Foreign currency translation                               343         512
                                                     ----------  ----------
Total goodwill                                           4,927       4,584
                                                     ----------  ----------
Other intangibles at the beginning of the year             138          --
Other intangibles acquired during the year                  --         142
Foreign currency translation                                13          22
Amortization expense                                       (39)        (26)
                                                     ----------  ----------
Total other intangibles                                    112         138
                                                     ----------  ----------
Total goodwill and other intangible assets, net     $    5,039  $    4,722
                                                     ==========  ==========`





Amortization expense for the Company's intangible assets was approximately
$39,000 and $26,000 for the year ended December 31, 2004 and 2003, respectively.
Based on the intangible assets held at December 31, 2004, and exchange
rates in effect as of the balance sheet date, the Company expects to recognize
amortization expense of approximately $35,000 in each of the years from 2005 to
2007, and approximately $7,000 in 2008.

Accrued Liabilities (in thousands):

`December 31,
                                                    --------------------
                                                      2004       2003
                                                    ---------  ---------
Payroll and related expenses                       $  13,052  $   7,366
Accrued income taxes                                   4,616      4,108
Legal, accounting and professional fees                1,620      1,122
Clinical studies                                       1,404         --
Professional training courses                            666        227
Travel and entertainment                                 466        621
Other                                                  2,225      1,255
                                                    ---------  ---------
                                                   $  24,049  $  14,699
                                                    =========  =========`



4. NOTES PAYABLE

In 1997 and 1998, the Company entered into two equipment financing lines
totaling $650,000.  Prior to the lines' expirations, the Company had drawn down
$541,800, which was collateralized by the related equipment.  Both of these
lines were repaid entirely in June 2002.  The Company issued warrants to
purchase an aggregate of 18,358 shares of convertible preferred stock to the
lenders in connection with these lines at a weighted-average exercise price of
$0.62 per share.  To effect a cashless exercise of the warrants, 17,601 shares
of common stock were issued subsequent to the Company's initial public offering.
All warrants related to the equipment financing lines were exercised in 2002.

5. CONVERTIBLE PROMISSORY NOTES

Between July 2001 and February 2002, the Company raised $13,300,000 through
the sale of convertible promissory notes with several affiliates pursuant to a
loan agreement.  The convertible promissory notes bore interest at 10% rate per
annum.  The outstanding principal and accrued interest were repaid upon the
closing of the Company's initial public offering.  In addition, in November
2001, the Company raised $700,000 through the sale of a convertible promissory
note to one affiliate pursuant to the same loan agreement.  The principal and
accrued interest due on this note automatically converted into 49,090 shares of
the Company's common stock at the initial public offering price of $15.00 per
share.  As required by the terms of the loan agreement, upon the closing date of
the Company's initial public offering, the Company issued warrants exercisable
for an aggregate of 99,334 shares of the Company's common stock at an exercise
price of $0.01 per share to the holders of the convertible promissory notes.  As
of December 31, 2004, all warrants have been exercised.

The Company allocated the gross proceeds received from the convertible
promissory notes and accrued interest to the convertible promissory notes and
the warrants, based on their relative fair values.  This allocation resulted in
$13,300,000 of the proceeds being assigned to the convertible promissory note
and $1,540,500 being assigned to the warrants.  The warrants were valued at the
May 22, 2002 issuance date using the Black-Scholes pricing model.  The Company
recognized the allocated fair value of the warrants of $1,540,500 as an
immediate charge to interest expense.  Based on the difference between the
effective conversion price of the proceeds allocated to the convertible
promissory notes and the fair market value of the common stock at the issuance
date, the Company determined that the allocated value of the convertible
promissory notes contained a beneficial conversion feature.  The beneficial
conversion feature, amounting to $1,540,500, represented additional interest
yield on the convertible promissory notes and was also recognized as an
immediate charge to interest expense.

6. ACQUISITION

In February 2003, the Company purchased all of the outstanding stock of
Sanatis, a privately-held developer and manufacturer of orthopedic biomaterials
based in Rosbach, Germany.  The acquisition was made to add Sanatis' experience
developing and manufacturing orthopedic biomaterials and to complement the
Company's existing patent portfolio with Sanatis' intellectual property
surrounding calcium-based biomaterials and delivery technologies.  The total
purchase consideration for Sanatis consisted of $4,492,000 in cash, and other
acquisition costs of $201,000.  In December 2003, the Company paid an additional
$157,000 in cash to settle a contract Sanatis had with a third party prior to
its acquisition.  In accordance with SFAS No. 141, "Business Combinations," this
amount was included in the allocation of the purchase price to goodwill.

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

`Accounts receivable, net                            $       16
Other current assets                                        17
Property and equipment, net                                 76
Other assets                                                67
Assumed liabilities                                       (176)
Purchased in-process research and development              636
Goodwill                                                 4,072
Patents                                                    142
                                                     ----------
                                                    $    4,850
                                                     ==========`





The fair value of the identifiable assets, including the portion of the
purchase price attributed to the patents and purchased in-process research and
development was determined by management.  The income approach was used to value
Sanatis' patents and purchased in-process research and development, which
included an analysis of the completion costs, cash flows, other required assets
and risk associated with achieving such cash flows.  The present value of these
cash flows was calculated with an effective tax rate of 40% and a discount rate
of 25% for the patent and purchased in-process research and development.  No
amount of goodwill is expected to be deductible for tax purposes.

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

The following unaudited pro forma financial information is based on the
respective historical financial statements of the Company and Sanatis.  The
unaudited pro forma financial information reflects the consolidated results of
operations as if the acquisition of Sanatis occurred at the beginning of each of
the periods presented 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 transaction been completed at the beginning of the periods
presented, 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,
                                        ----------------------
                                            2003       2002
                                          ---------  ---------
                                               (unaudited)

Net sales                                $ 131,028  $  76,492
Net income (loss)                        $  27,286  $ (15,393)

Net income (loss) per share:

Basic                                    $    0.71  $   (0.63)
                                          =========  =========
Diluted                                  $    0.65  $   (0.63)
                                          =========  =========

Weighted-average shares outstanding:

Basic                                       38,433     24,405
                                          =========  =========
Diluted                                     42,090     24,405
                                          =========  =========`





7. COMMITMENTS AND CONTINGENCIES

Operating leases

The Company has operations headquartered in an approximately 107,000 square
foot facility in Sunnyvale, California.  The facility is leased through August
2014.  Under the terms of the lease agreement, the Company has an option to rent
an adjacent existing facility as well as an option to have additional square
footage built in the same surrounding campus.

The Company's European operations are headquartered in an
approximately 22,000 square foot facility 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 most of the
major countries in Europe as well as Japan and Canada, with expiration dates
through 2013.

The Company records rent expense on a straight-line basis.  In 2004, the
Company also received cash incentives of $3.2 million from its landlord to be
used for leasehold improvements.  As of December 31, 2004 and 2003, deferred
rent of approximately $3,923,000 and $24,000, respectively had been recorded.
The Company recognized rent expense of $2.7 million, $1.4 million and $1.2
million during 2004, 2003 and 2002, respectively.

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

`Fiscal year ending December 31,
                                                                      
2005                                                        $   2,260
2006                                                            2,165
2007                                                            2,127
2008                                                            2,118
2009                                                            2,210
Thereafter                                                      9,548
                                                             ---------
Total                                                       $  20,428
                                                             =========`





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

In December 2003, the Company entered into a lease termination agreement to
terminate its facility lease in May 2004 which was due to expire in March 2005.
In accordance with the provision of SFAS No. 146 "Accounting for Costs
Associated with Exit or Disposal Activities," a lease termination charge of
$1,200,000 was recorded in the year ended December 31, 2003 as a general and
administrative expense.  In addition, the amortization of the remaining
leasehold improvements at that facility were accelerated and were fully
amortized by the second quarter of 2004.

Indemnification Agreements

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

The Company has entered into indemnification agreements
with its directors and officers that may require the Company to indemnify its
directors and officers against liabilities that may arise by reason of their
status or service as directors or officers, other than liabilities arising from
willful misconduct of a culpable nature; to advance their 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 April 2004, the Company filed two patent infringement suits against
Disc-O-Tech Medical Technologies Ltd., an Israel-based company doing business in
the United States as Disc Orthopaedic Technologies Inc. ("Disc-O-
Tech").  The Company filed suit in the United States District Court in
Delaware and in the International Trade Commission ("ITC") in
Washington, D.C.  In September 2004, the ITC entered an Order barring Disc-O-
Tech from all further importation of its SKy Bone Expander device into the
United States and from engaging in any further sales activities and uses of such
imported products, which thereby terminated the ITC proceeding in the Company's
favor.  An enforcement proceeding against Disc-O-Tech in the ITC may later be
initiated if it is determined that Disc-O-Tech is not complying fully with the
ITC Order.  In Delaware, the Company's complaint presently alleges, among other
things, that by importing, manufacturing, distributing and promoting their SKy
Bone Expander device and related tools for use in kyphoplasty procedures, Disc-
O-Tech is willfully infringing five of the Company's U.S. patents, all of which
generally concern the use of various medical devices to repair spinal
compression fractures, and seeks enhanced damages and a permanent injunction for
its willful infringement.  Trial is set for June 2005.  The Company is using the
information discovered during the ITC proceeding about Disc-O-Tech's business
activities to prosecute its case against Disc-O-Tech in Delaware and will
continue to do so vigorously.  No provision for any liability that may result
upon the resolution of this matter has been made in the accompanying financial
statements.

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. INITIAL PUBLIC OFFERING

On May 17, 2002, the Company completed an initial public offering in
which it sold 6,000,000 shares of common stock at $15.00 per share for net cash
proceeds of approximately $82,400,000, net of underwriting discounts,
commissions and other offering costs.  Upon the closing of the offering, all the
Company's outstanding shares of redeemable convertible preferred stock converted
into 26,151,288 shares of common stock.  On May 29, 2002, the underwriters
exercised the over-allotment option to purchase an additional 900,000 shares,
resulting in net cash proceeds of approximately $12,555,000.

9. REDEEMABLE CONVERTIBLE PREFERRED STOCK

In January 2002, 140,000 shares of the Company's redeemable convertible
preferred stock converted to common stock.  Upon the closing of the Company's
initial public offering in May 2002, the remaining outstanding shares of
redeemable convertible preferred stock converted into 26,151,288 shares of
common stock.

10. STOCKHOLDERS' EQUITY (DEFICIT)

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, 2004.

The Company issued shares of its common stock to certain employees under
stock purchase agreements, some of which contained repurchase provisions in the
event of termination of employment.  The shares are generally released from
repurchase provisions ratably over four years.  Included in common stock as of
December 31, 2004 and December 31, 2003 are none and 12,501 shares subject to
the Company's right of repurchase, respectively.

Employee Stock Purchase Plan

In April 2002, the Board of Directors adopted the 2002 Employee Stock
Purchase Plan ("2002 ESPP"), under which eligible employees are permitted to
purchase common stock at a discount through payroll deductions.  750,000 shares
of common stock were originally reserved for issuance and is increased on the
first day of each fiscal year, commencing in 2003, by an amount equal to the
lesser of (i) 1,500,000, (ii) 2.0% of the outstanding shares of common stock on
such date or (iii) an amount as determined by the Board of Directors.  The
Company reserved an additional 747,000 shares of common stock for issuance in
2003.  No additional shares were reserved for issuance in 2004.  The 2002 ESPP
contains consecutive, overlapping twenty-four month offering periods.  Each
offering period includes four six-month purchase periods.  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 initial offering period commenced on May 17, 2002, the effective
date of the Company's initial public offering.  At December 31, 2004,
approximately 983,000 shares of common stock remained reserved for future
issuance under the 2002 ESPP.

Director Option Plan

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.
200,000 shares of common stock were originally reserved for issuance and will be
increased on the first day of each fiscal year, commencing in 2003, by an amount
equal to the lesser of (i) the number of shares subject to options granted under
the 2002 Director Option Plan in the prior fiscal year or (ii) an amount as
determined by the Board of Directors.  There were no additional shares reserved
and approximately 58,000 stock options were granted under the 2002 Director
Option Plan in 2004.  There were no stock options granted and no additional
shares reserved under this plan in 2002 or 2003.

Stock 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.  There were 2,500,000 shares of
common stock originally reserved for issuance, and that amount is increased
on the first day of each fiscal year, commencing in 2003, by an amount equal to
the lesser of (i) 3,500,000, (ii) 5.0% of the outstanding shares of common stock
on the last day of the preceding fiscal year or (iii) an amount as determined by
the Board of Directors.  There were 1,867,817 and 1,971,987 additional shares
reserved for issuance in 2003 and 2004, respectively.

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
were 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.

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 are as follows:

`Options Outstanding
                                            ---------------------------------------------
                                                    Employees             Non-Employees
                                            ----------------------  ---------------------
                                                         Weighted               Weighted
                                 Shares                   Average                Average
                                Available    Number of   Exercise   Number of   Exercise
                                for Grant     Shares       Price      Shares      Price
                               -----------  -----------  ---------  ----------  ---------
Balances, January 1, 2002         965,350    6,377,384  $    0.83     948,834  $    0.87

Additional shares reserved      2,500,000           --         --          --         --
Shares repurchased                 30,207           --         --          --         --
Options granted                (2,223,000)   2,151,500       9.17      71,500       2.77
Options exercised                      --   (1,416,022)      0.71    (326,270)      0.77
Options cancelled                 980,981     (980,981)      1.04          --         --
                               -----------  -----------  ---------  ----------  ---------

Balances, December 31, 2002     2,253,538    6,131,881       3.79     694,064       1.04
Additional shares reserved      1,867,817           --         --          --         --
Options granted                (2,150,500)   2,113,500      15.68      37,000       9.92
Options exercised                      --   (1,453,406)     17.03    (421,459)     15.16
Options cancelled                 494,842     (489,842)      4.56      (5,000)      3.00
                               -----------  -----------  ---------  ----------  ---------

Balances, December 31, 2003     2,465,697    6,302,133       8.25     304,605       1.91
Additional shares reserved      1,971,987           --         --          --         --
Options granted                (3,044,300)   2,986,800      24.29      57,500      24.40
Options exercised                      --   (1,441,228)      4.33    (100,316)      1.25
Options cancelled                 475,897     (475,897)     18.43          --         --
                               -----------  -----------  ---------  ----------  ---------

Balances, December 31, 2004     1,869,281    7,371,808  $   14.85     261,789  $    7.10
                               ===========  ===========  =========  ==========  =========`





The options outstanding and exercisable at December 31, 2004 are as
follows:

`Options Outstanding            Options Exercisable
                               -----------------------------------  ---------------------
                                             Weighted
                                              Average    Weighted               Weighted
                                             Remaining    Average                Average
           Range of              Number     Contractual  Exercise    Options    Exercise
       Exercise Prices         Outstanding  Life in Years  Price    Exercisable   Price
------------------------------ -----------  -----------  ---------  ----------  ---------
            $0.05                 100,000         3.81  $    0.05     100,000  $    0.05
            $0.13                  14,629         4.50       0.13      14,629       0.13
            $0.31                  45,850         5.10       0.31      45,850       0.31
            $0.77                 261,762         5.22       0.77     261,762       0.77
            $1.00               1,290,089         6.21       1.00   1,093,577       1.00
            $3.00                 230,577         7.18       3.00     118,623       3.00
        $6.95 - $7.00             192,008         7.76       6.96      62,981       6.96
        $8.00 - $9.50             461,377         8.14       9.09     129,372       9.16
        $9.98 - $12.67          1,062,006         7.71      12.25     506,568      12.24
       $15.40 - $20.83          1,154,636         8.79      17.90     337,511      17.39
       $20.96 - $26.13          2,351,663         9.44      24.29     230,086      24.36
       $26.29 - $30.28            469,000         9.45      27.30      20,256      28.05
                               -----------  -----------  ---------  ----------  ---------
                                7,633,597         8.11  $   14.59   2,921,215  $    7.37
                               ===========  ===========  =========  ==========  =========

Employees                       7,371,808         8.15  $   14.85   2,733,111  $    7.72
Non-employees                     261,789         7.15       7.10     188,104       2.25
                               -----------  -----------  ---------  ----------  ---------
                                7,633,597         8.11  $   14.59   2,921,215  $    7.37
                               ===========  ===========  =========  ==========  =========`



At December 31, 2003, there were 2,149,617 options outstanding granted to
employees and 260,853 options outstanding granted to non-employees which were
exercisable.

11. 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 20% 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 of $2,000 per calendar year.  The Company's
matching contributions totaled $620,000 and $372,000 in 2004 and 2003,
respectively.

12. PURCHASED IN-PROCESS RESEARCH AND DEVELOPMENT

In August 2002, the Company entered into a patent sublicense agreement
with Bonutti Research Inc. for the rights to a series of patents issued to Dr.
Peter Bonutti.  Under the terms of the agreement, the Company 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 orthopedic applications in joints, ligaments, cartilage, nerves or
tendons outside of the spine.  The Company paid $12,250,000 in cash for the
rights, all of which was immediately expensed to purchased in-process research
and development in August 2002.  The acquisition cost was immediately expensed
to operations as at the time of purchase it was determined that the technology
acquired would be used to develop products that have not been approved for sale
by regulatory authorities, and the in-process projects to which the patents may
apply had not yet reached technological feasibility and had no alternative
future uses.  In addition, the Company also entered into a two year consulting
agreement with Dr. Peter Bonutti under which the Company paid $250,000.  The
prepayment was capitalized and recognized as research and development expense
ratably throughout the two year consulting period.

13. RELATED PARTY TRANSACTIONS

In August 1996, the Company entered into two consulting agreements with
consultants who are stockholders of the Company, one of whom was formerly a
member of the Board of Directors.  Aggregate amounts paid for services for the
year ended December 31, 2004, 2003 and 2002 were $216,000, $216,000 and
$217,000, respectively.

In October 2001, the Company entered into an agreement to loan $2,889,000 to
its former President and Chief Executive Officer, Gary Grenter, for the purchase
of a primary residence.  The note was non-interest bearing and was
collateralized by a deed of trust in the related primary residence.  As of
December 31, 2003, all outstanding balances were paid in full.

14. INCOME TAXES

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

`Year Ended December 31,
                                                    -------------------------------
                                                      2004       2003       2002
                                                    ---------  ---------  ---------
U.S.                                               $  35,153  $  14,636  $ (15,316)
International                                            464     (1,313)       (22)
                                                    ---------  ---------  ---------
Total income (loss) before income taxes            $  35,617  $  13,323  $ (15,338)
                                                    =========  =========  =========

Current
  Federal                                          $   7,892  $   4,152  $      --
  State                                                1,285        907         --
  Foreign                                                216        500         --
                                                    ---------  ---------  ---------
    Total current                                      9,393      5,559         --
                                                    ---------  ---------  ---------

Deferred
  Federal                                              4,286    (15,803)        --
  State                                                  433     (3,336)        --
  Foreign                                               (212)      (420)        --
                                                    ---------  ---------  ---------
    Total deferred                                     4,507    (19,559)        --
                                                    ---------  ---------  ---------

Total provision (benefit) for income taxes         $  13,900  $ (14,000) $      --
                                                    =========  =========  =========`



The Company's income taxes payable for federal, state, and foreign purposes
have been reduced by the tax benefits associated with dispositions of employee
stock options.  The Company received an income tax benefit of approximately
$8,741,000 and $3,496,000 in 2004 and 2003, respectively, calculated as the
difference between the fair market value and the option exercise price on the
date of exercise.



At December 31, 2004, the Company had approximately
$14,400,000 and $10,000,000 in federal and state net operating loss
carryforwards, respectively, to reduce future taxable income.  The federal and
state carryforwards have expiration dates beginning in 2021 and 2007,
respectively, if not utilized.

At December 31, 2004, the Company had research and development tax credit
carryforwards of approximately $2,195,000 and $2,221,000 for federal and state
income tax purposes, respectively.  If not utilized, the federal research and
development tax credit carryforwards will expire beginning in 2012.  The state
research and development tax credit can be carried forward indefinitely.

The Tax Reform Act of 1986 limits the use of net operating loss and tax
credit carryforwards in certain situations where changes occur in the stock
ownership of a company.  Ownership changes, as defined, occurred on August 8,
1996, December 14, 1999 and May 17, 2002.  In accordance with Internal Revenue
Code Section 382, utilization of the carryforwards is subject to annual
limitation.  The annual limitation is not expected to result in the expiration
of net operating losses prior to utilization.

Temporary differences and carryforwards that gave rise to significant
portions of deferred tax assets are as follows (in thousands):

`December 31,
                                                         --------------------
                                                           2004       2003
                                                         ---------  ---------
Net operating loss carryforwards                        $   5,507  $  13,850
Research and development credit carryforwards               3,638      2,051
Capitalized research and development costs                    479        491
Purchased research and development                          3,451      4,070
Other, accruals and reserves                                4,471      1,163
                                                         ---------  ---------
    Total deferred tax assets                           $  17,546  $  21,625
                                                         =========  =========`



Management periodically evaluates the recoverability of the deferred tax
assets and recognizes the tax benefit only as reassessment demonstrates that
they are realizable.  At such time, if it is determined that it is more likely
than not that the deferred tax assets are realizable, the valuation allowance
will be adjusted.  At December 31, 2004 and 2003, the Company did not provide a
valuation allowance against its deferred tax asset 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 (benefit) differed
from the provision (benefit) computed at the U.S. statutory tax rate as
follows:

`Year Ended December 31,
                                                    -------------------------------
                                                      2004       2003       2002
                                                    ---------  ---------  ---------
Federal statutory rate                                  35.0 %     34.0 %    (34.0)%
State, net of federal benefit                            4.7        5.8       (5.8)
Deferred stock-based compensation,
     net of tax benefit                                   --      (35.7)        --
Tax reserves                                            (0.2)      30.6         --
Other permanent difference                               4.0        1.6       13.3
Change in valuation allowance                             --     (142.0)      32.2
Utilization of net operating loss                         --         --       (5.5)
Research and development tax credits                    (4.5)        --       (0.2)
                                                    ---------  ---------  ---------
Total provision(benefit) for income taxes               39.0 %   (105.7)%      0.0 %
                                                    =========  =========  =========`





15.QUARTERLY FINANCIAL DATA (UNAUDITED)

The following tables contain selected unaudited Consolidated Statement of
Operations data for each quarter of 2004 and 2003 (in thousands, except per
share amounts):

`Year 2004 Quarter Ended
                                                 -------------------------------------------
                                                 Mar. 31,    June 30,   Sept. 30,  Dec. 31,
                                                 ---------   ---------  ---------  ---------

Net sales                                       $  44,433   $  50,745  $  55,811  $  62,425
Gross profit                                       39,516      44,745     49,564     54,855
Net income                                      $   4,813   $   4,703  $   6,132  $   6,069
Net income per share:
Basic                                           $    0.12   $    0.12  $    0.15  $    0.15
Diluted                                         $    0.11   $    0.11  $    0.14  $    0.14
Weighted-average shares outstanding:
Basic                                              39,761      40,145     40,733     41,147
Diluted                                            43,332      43,452     43,734     43,938




                                                          Year 2003 Quarter Ended
                                                 -------------------------------------------
                                                 Mar. 31,    June 30,   Sept. 30,  Dec. 31,
                                                 ---------   ---------  ---------  ---------

Net sales                                       $  25,137   $  31,081  $  35,145  $  39,665
Gross profit                                       21,787      27,131     30,554     34,762
Net income                                      $     541 * $   2,820  $   4,712  $  19,250 **
Net income per share:
Basic                                           $    0.01   $    0.07  $    0.12  $    0.49
Diluted                                         $    0.01   $    0.07  $    0.11  $    0.45
Weighted-average shares outstanding:
Basic                                              37,566      38,069     38,767     39,298
Diluted                                            40,895      41,429     42,539     43,082

* Net income includes purchased in-process research and development expense of $636,000.
** Net income includes lease termination cost of $1,200,000 and income tax benefit of $14,500,000.


KYPHON INC. 
SCHEDULE II 
VALUATION AND QUALIFYING ACCOUNTS 
FOR THE YEARS ENDED DECEMBER 31, 2002, 2003 AND 2004
(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 2002                        $        100            3             3  $       100
  Fiscal year ended 2003                                 100          404             4          500
  Fiscal year ended 2004                        $        500          737           183  $     1,054

Allowance for inventories valuation:

  Fiscal year ended 2002                        $        191          470            54  $       607
  Fiscal year ended 2003                                 607          550           532          625
  Fiscal year ended 2004                        $        625          158           254  $       529

Valuation allowance for deferred tax assets:

  Fiscal year ended 2002                        $     15,249        5,149            --  $    20,398
  Fiscal year ended 2003                              20,398           --        20,398           --
  Fiscal year ended 2004                        $         --           --            --  $        --`



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

Not applicable.

ITEM 9A.  CONTROLS AND PROCEDURES

An evaluation of the effectiveness of our disclosure controls and
procedures "disclosure controls and procedures" (as defined in
Rules 13a-15(e) and 15(d)-15(e) of the Securities and Exchange Act of 1934,
as amended) as of the end of the period covered by this report was carried out
under the supervision and with the participation of our management, including
our chief executive officer and chief financial officer. Based on that
evaluation, our chief executive officer and chief financial officer have
concluded that our disclosure controls and procedures are effective to ensure
that information we are required to disclose in reports that we file or submit
under the Securities and Exchange Act of 1934, as amended, is recorded,
processed, summarized and reported within the time periods specified in the
Securities Exchange Commission's rules and forms.

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



Management's Report on Internal Control over Financial Reporting is
incorporated by reference to Item 8 of this Annual Report on Form 10-K.

ITEM 9B.  OTHER INFORMATION

None.



PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE
REGISTRANT

The information required by this Item is incorporated by reference to the
definitive proxy statement for our 2005 Annual Meeting of Stockholders to be
filed with the Securities and Exchange Commission within 120 days after the end
of our 2004 fiscal year (the "2005 Proxy Statement").

ITEM 11. EXECUTIVE COMPENSATION

The information required by this Item is incorporated by reference to the
2005 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
2005 Proxy Statement.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

The information required by this Item is incorporated by reference to the
2005 Proxy Statement.

ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES

The information required by this Item is incorporated by reference to the
2005 Proxy Statement.





PART IV

ITEM 15.  EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

(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                                                                                                                                                                    
|--------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|          |  |                                                                                                                                                                                
|3.2(1)    |  | Amended and Restated Certificate of Incorporation of the
Registrant.                                                                                                           
|          |  |                                                                                                                                                                                
|3.4(1)    |  | Bylaws of the Registrant.                                                                                                                                                      
|          |  |                                                                                                                                                                                
|4.1(1)    |  | Specimen common stock certificate of the Registrant.                                                                                                                           
|          |  |                                                                                                                                                                                
|10.1*(1)  |  | Form of Indemnification Agreement for directors and executive
officers.                                                                                                        
|          |  |                                                                                                                                                                                
|10.2*(1)  |  | 1996 Stock Option Plan, including form of option
agreement.                                                                                                                    
|          |  |                                                                                                                                                                                
|10.3*(1)  |  | 2002 Stock Plan, including form of option agreement.                                                                                                                           
|          |  |                                                                                                                                                                                
|10.4*(1)  |  | 2002 Employee Stock Purchase Plan, including form of employee
stock purchase plan subscription agreement.                                                                      
|          |  |                                                                                                                                                                                
|10.5*(1)  |  | 2002 Director Option Plan, including form of option
agreement.                                                                                                                 
|          |  |                                                                                                                                                                                
|10.8(1)   |  | Lease dated January 27, 2000 for office space located at 1350
Bordeaux Drive, Sunnyvale, CA 94089 and Second Amendment to Lease dated November
29, 2001.                       
|          |  |                                                                                                                                                                                
|10.8.1(1) |  | Third Amendment to Lease dated March 29, 2002 for office space
located at 1350 Bordeaux Drive, Sunnyvale, CA 94089.                                                            
|          |  |                                                                                                                                                                                
|10.9*(1)  |  | Employment Agreement between the Registrant and Gary L. Grenter
dated July 16, 2001.                                                                                           
|          |  |                                                                                                                                                                                
|10.10(1)  |  | Promissory Note Secured by Deed of Trust between the Registrant
and Gary L. Grenter dated December 31, 2001.                                                                   
|          |  |                                                                                                                                                                                
|10.11(1)  |  | Amended and Restated Stockholder Rights Agreement effective as
of December 14, 1999, among the Registrant and certain stockholders of the
Registrant.                          
|10.12*(2) |  | Employment Agreement between the Registrant and Richard W. Mott
dated September 3, 2002.                                                                                       
|10.13+(2) |  | Sublicense Agreement effective as of August
19, 2002, between the Registrant and Bonutti Research, Inc.                                                                        
|10.14(3)  |  | Stock Purchase Agreement by and between Kyphon and the
shareholders of Sanatis GmbH, dated February 15, 2003.                                                                  
|10.15(4)  |  | Lease dated September 18, 2003 for office spaces located at
1221 Crossman Avenue and 480 Java Drive, Sunnyvale,
California.                                                    
|10.16*(5) |  | Form of Severance Agreement entered into by and between Kyphon Inc.
and its executive officers.                                                                                
|10.17*(5) |  | Severance Agreement, dated January 28, 2005, entered into by and between Kyphon Inc.
and Richard W. Mott.                                                                      
|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)Incorporated by reference from
our Registration Statement on Form S-1 (Registration No. 333-83678), which was
declared effective on May 16, 2002.

(2)Incorporated by reference from
our Quarterly Report on Form 10-Q filed on November 13, 2002.

(3)Incorporated by reference from
our Current Report on Form 8-K filed on March 7, 2003.

(4)Incorporated by reference from
our Quarterly Report on Form 10-Q filed on November 14, 2003.

(5)Incorporated by reference from
our Current Report on Form 8-K filed on February 1, 2005.

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

+ Confidential treatment requested on portions of this
exhibit.  Unredacted versions of this exhibit have been filed separately with
the Commission.

---

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 2nd day of
March, 2005.

Kyphon Inc.

KNOW ALL MEN AND WOMEN BY THESE PRESENTS, that each person whose
signature appears below constitutes and appoints Richard W. Mott and Arthur T.
Taylor, his attorneys-in-fact, each with the power of substitution, for him in
any and all capacities, to sign any amendments to this Annual 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 Act of
1933, this Registration Statement has been signed by the following persons 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)                      |  | March 2, 2005
|                                                      |  |                                                                                                    |  |              
|/s/ Arthur T. Taylor
ARTHUR T. TAYLOR                 |  | Vice President, Chief Financial
Officer and Treasurer (Principal Accounting and Financial Officer) |  | March 2, 2005
|                                                      |  |                                                                                                    |  |              
|/s/ JAMES T.
TREACE
James T. Treace                   |  | Chairman of the Board                                                                              |  | March 2, 2005
|                                                      |  |                                                                                                    |  |              
|/s/ STEPHEN M. CAMPE                                  |  | Director                                                                                           |  | March 2, 2005
|Stephen M. Campe                                      |  |                                                                                                    |  |              
|                                                      |  |                                                                                                    |  |              
|/s/ DOUGLAS W.
KOHRS
Douglas W. Kohrs                 |  | Director                                                                                           |  | March 2, 2005
|                                                      |  |                                                                                                    |  |              
|/s/ JACK W. LASERSOHN
Jack W. Lasersohn               |  | Director                                                                                           |  | March 2, 2005
|                                                      |  |                                                                                                    |  |              
|/s/ KAREN D. TALMADGE,
PH.D.
Karen D. Talmadge, Ph.D. |  | Executive Vice President, Co-Founder, Chief Science Officer and Director                           |  | March 2, 2005
|                                                      |  |                                                                                                    |  |              
|/s/ ELIZABETH H. WEATHERMAN
Elizabeth H. Weatherman   |  | Director                                                                                           |  | March 2, 2005
|/s/ LOUIS J. LAVIGNE. JR.
Louis J. Lavigne, Jr.       |  | Director                                                                                           |  | March 2, 2005

---