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, 2005 or

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

Commission file number    000-49804

Kyphon Inc.



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

1221 Crossman Avenue
Sunnyvale, California      94089

(408) 548-6500

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



|Title of each class: 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 if the
registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
    Yes  
x    No

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

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

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

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

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

The aggregate market value of the voting stock held by non-affiliates of the
registrant, based upon the closing sale price of the common stock on June 30,
2005 (which is the last business day of registrant's most recently completed
second fiscal quarter), as reported on the Nasdaq National Market was
approximately $1.1 billion.  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, 2006, the registrant had 44,059,289 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 2005 ANNUAL REPORT ON FORM 10-K
                               TABLE OF CONTENTS



|Part I.    |                                                                                                              | Page
|---------- | ------------------------------------------------------------------------------------------------------------ | ----
|Item 1.    | Business                                                                                                     | 4   
|Item 1A.   | Risk Factors                                                                                                 | 23  
|Item 1B.   | Unresolved Staff Comments                                                                                    | 33  
|Item 2.    | Properties                                                                                                   | 33  
|Item 3.    | Legal Proceedings                                                                                            | 34  
|Item 4.    | Submission of Matters to a Vote of Security Holders                                                          | 34  
|Part II.   |                                                                                                              |     
|Item 5.    | Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities | 35  
|Item 6.    | Selected Financial Data                                                                                      | 36  
|Item 7.    | Management's Discussion and Analysis of Financial Condition and Results of Operations                        | 37  
|Item 7A.   | Quantitative and Qualitative Disclosures about Market Risk                                                   | 49  
|Item 8.    | Financial Statements and Supplementary Data                                                                  | 51  
|Item 9.    | Changes in and Disagreements with Accountants on Accounting and Financial Disclosure                         | 78  
|Item 9A.   | Controls and Procedures                                                                                      | 78  
|Item 9B.   | Other Information                                                                                            | 78  
|Part III.  |                                                                                                              |     
|Item 10.   | Directors and Executive Officers of the Registrant                                                           | 78  
|Item 11.   | Executive Compensation                                                                                       | 78  
|Item 12.   | Security Ownership of Certain Beneficial Owners and Management, and Related Stockholder Matters              | 78  
|Item 13.   | Certain Relationships and Related Transactions                                                               | 78  
|Item 14.   | Principal Accountant Fees and Services                                                                       | 78  
|Part IV.   |                                                                                                              |     
|Item 15.   | Exhibits and Financial Statement Schedules                                                                   | 79  
|Signatures |                                                                                                              | 81  



PART 1

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

ITEM 1.	BUSINESS

Overview

Kyphon Inc., a Delaware corporation founded in 1994 and
headquartered in Sunnyvale, California, is a global medical device company
specializing in the design, manufacture and marketing of medical devices to
treat and restore spinal anatomy 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
balloon kyphoplasty.  Our commercial products consist of our KyphX®
instruments, used to treat spinal fractures during balloon 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
spinal fracture treatments are either highly invasive or are only pain
management therapies.

We believe there are approximately 700,000 clinically-diagnosed spinal
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, 2005, we had trained approximately 8,000 physicians in the
United States, Europe and Asia-Pacific on the balloon kyphoplasty technique, and
these physicians had used our instruments in approximately 187,000 patients and
220,000 spinal factures.  To support these physicians, we have built a large and
growing worldwide direct sales organization that numbered in excess of 425
professionals as of December 31, 2005.  Balloon 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, balloon 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, our KyphOsTM calcium phosphate
cement, in December 2003, and we are now authorized to sell this material in
Europe.

In December 2005, we entered into a definitive agreement to acquire
InnoSpine, Inc., a privately held company focused on developing and marketing
its proprietary technology platform for the diagnosis and potential treatment of
axial low back pain due to disc degeneration, which acquisition was completed in
January 2006.  InnoSpine's initial technology, which was cleared for marketing
by the Food and Drug Administration (FDA) in April 2005, was developed with the
aim of improving the results available from existing discography techniques
through a novel diagnostic method known as Functional Anesthetic Discography
(FAD), which involves a single-use disposable device with no capital equipment
requirements.  In contrast to traditional provocative discography which relies
on delivery of fluid under pressure to provoke pain in a disc while the patient
is prone, FAD is a unique, minimally invasive procedure that utilizes a
catheter-based system anchored in the disc space to deliver mild anesthetic to a
candidate disc while the patient loads his or her spine in positions that cause
pain.  If the pain sensations from normal loading are relieved by anesthetic
delivery to the degenerated disc, then the disc can be identified for further
treatment.

We intend to pursue the research, development and commercialization of spine
products arising from these acquisitions and from our licenses to various
portfolios of patents we have acquired, including from Bonutti Research in
August 2002 and Dr. J. Lee Berger in April 2005, 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-spinal fracture treatment
technologies or biologics as well as technologies having application elsewhere
in the spine, as appropriate and consistent with our long-term vision for
Kyphon.

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 spinal fractures include trauma, cancerous and benign tumors and
infection.

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

- Increased Risk of Mortality

- Acute and Chronic Pain

- Health Effects Resulting from Organ Compression

- Functional Limitation

- Increased Risk of Additional Fractures

- Emotional Effects

Market Opportunity for the Treatment of Spinal 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 estimate 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 spinal 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 Spinal Fractures

When treating a patient with a spinal 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
spinal fractures, such as traumatic fractures in younger patients, these
procedures are highly invasive and especially risky for elderly patients.  As a
result, before the development of less invasive alternatives, physicians rarely
referred their patients with osteoporosis and cancer for surgical procedures to
repair spinal fractures, but instead prescribed therapies and treatments
designed to simply manage the pain.

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
spinal 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 healthcare;
- 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 spinal 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 balloon kyphoplasty.  Our
instruments have also been used in open surgical procedures.  We generally refer
to our instruments as the KyphX instruments.

Minimally invasive spinal fracture surgeries using our KyphX
instruments typically involve the insertion of two of our disposable proprietary
balloon devices into the fractured bone.  The 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 FDA in the U.S. for balloon
kyphoplasty.

We have trained approximately 8,000 physicians, including 3,000 overseas in
the use of our KyphX instruments.  We believe these physicians have used
our instruments to treat approximately 187,000 patients and 220,000 spinal
fractures worldwide.

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

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

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

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

Recently, we concluded an extensive review of the published clinical
literature describing the results for 897 patients treated with balloon
kyphoplasty and 2,408 patients treated with vertebroplasty.  The data in the
published literature demonstrate that balloon kyphoplasty is associated with a
statistically significantly lower procedure-related complication rate and a
statistically significantly lower procedure-related bone cement complication
rate, as compared to vertebroplasty, although bone cement leakage may still
occur with balloon kyphoplasty.  As a result, we have now introduced the
corresponding comparative claims into our educational and marketing
materials.

The Use of KyphX Instruments during Minimally Invasive Balloon
Kyphoplasty Spine Surgery

Spinal 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 balloon
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 Balloon Kyphoplasty Surgery Using Our KyphX
Instruments as the Standard of Care for Spinal Fracture Repair

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

- Educate Primary Care Physicians

- Expand Marketing Claims

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

- Expand our Global Commercial Reach

- Continue Revenue Growth Through New Product Development and
Acquisition

- Other Business Initiatives.

Our Products

With the acquisition of InnoSpine, Inc., we will have two product families,
Spinal Deformity Correction and Disc Repair and Regeneration.  Both product
families will be sold and supported through our existing sales
organization.

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

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

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.

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

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

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

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

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

We obtained a CE Mark, or a mark that allows us to market a product
throughout the European Union, 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.

Disc Repair and Regeneration.  This product family is
comprised currently of the products acquired from InnoSpine, Inc.  These
products are used in the diagnosis and potential treatment of axial low back
pain due to degenerative disc disease.  We believe that approximately 200,000
patients with persistent, severe axial back pain could be indicated for this
diagnostic procedure each year in the U.S. alone, including the majority of
patients undergoing spinal fusion at one or more levels.   We intend to
initiate full commercial launch during the second quarter of 2006.  A
single disposable product kit is comprised of an introducer needle, a spine
needle, an inflatable balloon anchor and syringes.  During the Functional
Anesthetic Discography (FAD) diagnostic procedure, a short acting local
anesthetic is delivered through the balloon catheter anchored in a spinal disc
suspected to be the source of a patient's low back pain.  The core balloon
catheter technology was cleared by the FDA in April 2005 for delivery of local
anesthetic, radiopaque contrast or saline solution to the intradiscal space.

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 425
professionals as of December 31, 2005.  Our target customer base includes the
approximately 21,000 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 2005, 2004 or 2003.

As of December 31, 2005, our U.S. sales organization was comprised
of 248 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.  We have also trained approximately
8,000 physicians in the U.S., Europe and Asia-Pacific to perform the balloon
kyphoplasty procedure with our KyphX instruments.

We have operated mainly in the United States, and 84%, 88% and 90% of our
sales were made in U.S. dollars in 2005, 2004 and 2003, respectively.  The
majority of our international sales are derived from European Union countries.
Our European operations are presently headquartered in Belgium with direct sales
organizations in the major European countries.  We anticipate continuing to
build direct sales organizations in the major European countries while
establishing distributor or agency arrangements in the smaller ones.  We intend
to follow a similar model in Europe to the one established in the United States,
working with internationally recognized physicians initially as we expand our
training, reimbursement and selling activities.  We are also planning to
establish an operational presence in Switzerland including manufacturing,
distribution and certain research and development activities, to support the
growth of our international business.

We are still in the early stages of initiating the sales process in selected
Asia-Pacific markets.  We have initially trained surgeons and sold products in
South Korea and China.  In 2004, we formed our Japanese subsidiary, Kyphon
Nippon KK, and have formulated and begun to execute on our clinical and
regulatory plans for Japan.  In addition, we have sold our products in Canada
through a direct sales force, and in 2006 we plan to sell our products in Brazil
and Mexico through distributors, and anticipate establishing presences in
certain additional Asian countries and Australia.

Reimbursement



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

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

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

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

As to procedures using our technology performed in hospital outpatient
departments, payment is based on the Ambulatory Payment Classification (APC)
under which the procedure is categorized.  The Centers for Medicare and Medicaid
Services (CMS), the Federal agency responsible for administering the Medicare
program, assigns procedures that are comparable, both clinically and in terms of
the resources required, to the same APCs.  For 2006, CMS assigned the balloon
kyphoplasty procedures using KyphX instruments, which are described by
the new Category I CPT codes (discussed above), to APC 0052 (Level IV
Musculoskeletal procedures except hand and foot) and to APC 274 (myelography).
Hospitals performing outpatient procedures for Medicare patients using our
products are paid the applicable APC payment rate for the outpatient procedure,
regardless of the actual cost for such treatment.

In addition to payments to hospitals for procedures using our technology,
Medicare makes separate payments to physicians for their professional services
under the national Medicare Physician Fee Schedule.  In all 50 states and in the
District of Columbia, Medicare reimburses physicians for their professional
services when they perform procedures using our KyphX instruments, and
reimburses them the same amount regardless of whether the procedure is inpatient
or outpatient.  Effective January 1, 2006, there are three new Category I CPT
codes, or reimbursement codes, describing procedures in which our products are
used: CPT codes 22523, 22524 and 22525.  The first two codes describe
performance of percutaneous vertebral augmentation, including cavity creation
(fracture reduction including biopsy when performed) using mechanical device,
one vertebral body, unilateral or bilateral cannulation (e.g., kyphoplasty), for
thoracic and lumbar procedures, respectively.  The third code describes
performance of the procedure on each additional thoracic or lumbar vertebral
body.  In addition, two existing radiologic codes, CPT codes 76012 and 76013,
were modified.  These codes now describe fluoroscopic and CT guidance, to
include specific reference to vertebral augmentation including cavity creation.

Although the reimbursement levels associated with the reimbursement codes for
kyphoplasty are greater than what physicians in some states previously received
for such procedures, they are also less than what physicians in other states
previously received which could make surgery with our products less attractive
to some physicians.  Physicians may believe or determine that the reimbursement
available under these new codes is not sufficient to support continued use of
our products to perform balloon kyphoplasty.  As of now, it is not possible to
assess whether the implementation of the new Category I CPT codes has had or
will have any material impact on the behavior of clinicians with respect to
their interest in performing the balloon kyphoplasty procedure.  At this time,
it is too early to predict with any degree of certainty the full impact of the
new Category I CPT codes on our business, although we have not seen any
significant impact in any geographic region to date.



In Europe, kyphoplasty has been assigned a code in the recently
implemented German OPS system.  In other European countries, we continue to
focus efforts on obtaining reimbursement coverage for the procedure, although no
assurances can be provided that such efforts will result in favorable outcomes
for us.  We are aware that in the past, one or more competitors has attempted to
adversely affect our ability to acquire timely and appropriate levels of
reimbursement in several foreign countries by seeking much lower levels of
reimbursement for their own competitive products that may not support the
pricing or anticipated pricing of our products in those markets.  We do not know
whether these efforts will continue or will be effective or broad in
application.  We are also aware that some foreign governments, including
Germany, are continuing to evaluate coverage and reimbursement for balloon
kyphoplasty, which ultimately may increase or decrease the reimbursement
available for procedures performed with our products.  Our business could be
harmed in countries where the level of reimbursement available is ultimately
decreased.  Notwithstanding all of these activities, we will continue to seek
appropriate levels of reimbursement in those markets using appropriate
measures.

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 January 2005
updating our facility to ISO 13485:2003 certified.  TUV is our notified body and
the audit is necessary for our European Community certification, which in turn
permits us to acquire and maintain CE marks for our products.  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
material audit findings as a result of these inspections.



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

The purchased components for our instruments are 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, diagnosis of
discogenic pain, treatment of spinal fractures and other spinal deformities and
disease states, dynamic stabilization initiatives, disc repair regeneration
initiatives, and evaluating several opportunities within the cancer initiatives.
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 $46.4 million, $22.2 million
and $16.0 million in 2005, 2004 and 2003, respectively.  Research and
development expense in 2005 included the license acquisition cost of $20.0
million and Berger license fee of $1.0 million.  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 diagnosis and 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 spinal 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 balloon kyphoplasty.  Competition is likely to
increase the awareness and frequency of alternative procedures to balloon
kyphoplasty.  We are also beginning to see introduction by competitors of
instruments designed to achieve either or both void creation and fracture
reduction, including knock-offs of our products in some Asia-Pacific countries.
These products are initially being marketed in the U.S., Europe and Asia as
supposedly more effective and less expensive than our KyphX products.
Numerous companies are developing and marketing materials, including
biomaterials, which may be used as bone filler materials.  Given the early stage
of many of these competitive marketing efforts, it is premature to determine
what, if any, impact these products may have on our sales growth.

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

Any products that we commercialize will be subject to intense competition.
Overall, we believe the primary competitive factors that affect our instruments
are the cost of our products and the cost of procedures performed with our
products, third-party payor coverage and reimbursement status, 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 third-
party payor reimbursement in various geographic markets in order to penetrate
those markets quickly.  Our ability to compete successfully will depend on our
ability to develop innovative products that reach the market in a timely manner
through our direct sales channel, receive adequate third-party payor coverage
and reimbursement and are safer, less invasive and less expensive than
alternatives available for the same condition.  Because of the size of the
potential market, we anticipate that companies will dedicate significant
resources to developing competing products and procedures.  Our technologies and
instruments may be rendered obsolete or uneconomical by technological advances
or entirely different approaches developed by one or more of our competitors.
We may also be forced to protect our market space through enforcement of our
intellectual property rights, which would be expensive to do and likely would
constitute a significant distraction to our executive team and which efforts
ultimately may not succeed.

Patents and Proprietary Technology

We believe that in order to have a competitive advantage, we must develop,
maintain and protect the proprietary aspects of our technologies.  We rely on a
combination of patents, trademarks, trade secrets, non-disclosure and other
contractual agreements and technical measures to protect our intellectual
property rights.  Kyphon®, KyphX®, KyphX HV-RTM and
KyphOsTM are some of our trademarks.  We have trademark rights in
these and others of our marks in the United States and have registrations issued
and pending in the United States and other countries for these and others of our
trademarks.  As of December 31, 2005, we had over 42 issued U.S.
patents, 30 issued foreign patents, 70 pending U.S. patent
applications, 100 pending foreign applications, including 26 patents that we
exclusively licensed from Bonutti Research in August 2002, and 7 patents and
patent applications that we licensed from Dr. J. Lee Berger in April 2005.

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

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

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

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.  This was the first time we enforced our patent rights against any
entity.  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, thereby terminating
the ITC proceeding in our favor.  In June 2005, the Delaware District court
entered a Consent Judgment permanently enjoining Disc-O-Tech from further
infringing our patent rights with its SKy Bone Expander device or products not
colorably different from the SKy Bone Expander, which took effect on July 22,
2005.  This Judgement bars further importation or selling of Disc-O-Tech's SKy
Bone Expander device or colorable variations of that device for performing
kyphoplasty in the U.S. market.  This concluded the litigation in our favor
without the possibility of further trial or appeal.  Disc-O-Tech, however,
remains a competitor abroad, in other jurisdictions where we have not pursued
them to date with our foreign patent rights, or may not be able to pursue them
at all.

In January 2006, Kyphon and Dr. Harvinder Sandhu, a well-respected
orthopaedic surgeon, formed an exclusive consulting relationship covering
various fields of minimally invasive spine diagnosis and therapy, including
treatment of spinal disc disorders and diagnosis of various spine conditions.
Previously, in November 2005, Dr. Sandhu agreed to exclusively license to Kyphon
his early invention rights concerning a directional bone tamp for treating
vertebral compression fractures for a cash payment of $5.0 million and a series
of payments totaling up to an additional $15.0 million.  The license also
includes a typical provision for a capped royalty stream on any future developed
product that practices Dr. Sandhu's technology.  In November 2005, Dr. Sandhu
and Kyphon filed suit in federal district court in Memphis, Tennessee against
Medtronic Sofamor Danek and several other related corporate entities seeking
compensatory and punitive damages and injunctive relief for breach of contract
and related covenants, trade secret theft, fraud, unjust enrichment, and
correction of inventorship of several patents and patent applications presently
owned by Sofamor Danek.  The suit also requests, among other relief, that
Sofamor Danek transfer to Dr. Sandhu ownership of the disputed patents and
patent applications.  The dispute concerns Dr. Sandhu's directional bone tamp
inventions exclusively licensed to Kyphon.  The complaint alleges that after
receiving a confidential disclosure of Dr. Sandhu's inventions, Sofamor Danek
later filed for several patents encompassing and claiming Dr. Sandhu's
inventions without naming him as inventor of that technology and that it also
incorporated Dr. Sandhu's inventions into its internal Equestra project
without his permission.  The litigation is in its early stages; no trial date
has yet been set.

In December 2005, we entered into a definitive agreement to acquire
InnoSpine, Inc., a privately held developer of a proprietary technology platform
for the diagnosis and potential treatment of axial low back pain due to disc
degeneration, which acquisition was completed in January 2006.  InnoSpine has
filed for patent protection on various aspects of the 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
in turn could adversely affect our business and our financial condition and
cause our stock price to decline.

Government Regulation

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

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

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

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

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

Our KyphX Inflatable Bone Tamps currently have 510(k) clearance for
use as conventional bone tamps for the reduction of fractures and/or the
creation of a void in cancellous bone in the spine (including use during balloon
kyphoplasty with KyphX HV-RBone Cement), hand, tibia, radius and
calcaneus.  The KyphX Inflation Syringe 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 balloon 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 a device cannot be cleared through the 510(k) process.  A
PMA must normally be supported by extensive data including, but not limited to,
technical, preclinical and clinical studies, manufacturing information and
labeling to demonstrate to the FDA's satisfaction the safety and effectiveness
of the device.

After a PMA is filed, the FDA begins an in-depth review of the submitted
information, which generally takes between one to three years, but may take
longer.  During this review period, the FDA may request additional information
or clarification of the information already provided.  Also, in many cases, an
advisory panel of experts from outside the FDA will be convened to review and
evaluate the application and provide recommendations to the FDA as to the
approvability of the device.  In addition, the FDA will conduct a preapproval
inspection of the manufacturing facility to ensure compliance with 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 low number of MDRs for our products,
although more may be required as the number of procedures performed with our
products increases.  Through 2005, we have not faced any product liability
litigation although such litigation is common in the medical device industry and
we may have to defend such litigation at some point in the future.

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

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

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

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

The federal False Claims Act prohibits any person from knowingly presenting,
or causing to be presented for payment, a false or fraudulent claim for payment
to the federal government.  Suits filed under the False Claims Act, known
as "qui tam" actions, can be brought by any individual (known
as a "relator" or, more commonly, "whistleblower") on behalf
of the government.  In addition, certain states have enacted laws modeled
after the federal False Claims Act.  The frequency of filing of qui
tam actions has increased significantly in recent years, causing greater
numbers of healthcare companies to have to defend a False Claim action.
Although we believe we are in substantial compliance with the
healthcare laws relevant to our Company, we are aware that a complaint against
us, which we believe is a qui tam complaint, was recently presented to a
U.S. Attorney's Office for consideration (See Item 1A. Risk Factors - "We
are aware that a complaint, which we believe is a qui tam complaint, is
being evaluated by a U.S. Attorney's Office in connection with our marketing and
sales practices, including those relating to the Medicare reimbursement
available to our customer hospitals.  If a subpoena, or an enforcement or other
action results from this investigation, our business and financial condition
could be adversely affected which could cause our stock price to decline").

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

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

International. International sales of medical devices are
subject to foreign government regulations, which vary substantially from country
to country.  The time required to obtain approval by a foreign country may be
longer or shorter than that required for FDA approval, and the requirements may
differ.  The primary regulatory authority in Europe is that of the European
Union, or EU, which consists of 25 countries encompassing most of the major
countries in Europe.  Other countries, such as Switzerland, have voluntarily
adopted laws and regulations that mirror those of the EU with respect to medical
devices.  The EU has 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.

Operating Segment and Geographic Information

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

Employees

As of December 31, 2005, we had a total of 885 employees, with 121 people in
operations, 89 people in research and development, 544 people in sales,
marketing and professional education and 131 people in general and
administrative.  None of our employees are represented by a labor union, and we
believe our employee relations are good.

Available Information

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

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

ITEM 1A.	RISK FACTORS

Factors Affecting Future Operating Results

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

Our current products offer orthopaedic surgeons and neurosurgeons,
interventional radiologists and interventional neuroradiologists the ability to
treat and restore spinal anatomy during balloon kyphoplasty.  We cannot assure
you that the market for the treatment of spinal fractures will continue to
generate significant or consistent demand for our KyphXinstruments.
Demand for our products could be significantly diminished by alternative
treatment methods, and by new technologies or products that replace and render
our products obsolete or too expensive.  Our future success is dependent upon,
among other factors, our ability to develop, obtain regulatory clearance or
approval for, manufacture, sell and achieve market acceptance of new products,
product extensions and improvements to our existing products.  The extent of,
and rate at which, market acceptance and penetration are achieved by future
products is a function of many variables.  These variables include price,
safety, efficacy, reliability, marketing and sales efforts, the availability of
adequate third-party coverage and reimbursement for procedures using our new
products and the existence of competing products and general economic conditions
affecting purchasing patterns.  Our ability to market and sell new products,
product extensions and improvements to our existing products may also be subject
to government regulation, including clearance and approval by the FDA and
foreign government agencies.  Any failure in our ability to successfully
develop, obtain regulatory approval for, manufacture, sell and achieve market
acceptance of our new products, product extensions or improvements to our
existing products could adversely affect our business and our financial
condition, which could cause our stock price to decline.

Our success is dependent upon the availability of adequate physician and
hospital reimbursement by third-party payors for balloon kyphoplasty procedures
using our KyphX instruments.

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

In addition, 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 balloon kyphoplasty procedures using our
products are performed, which could harm our revenues.

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

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

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

The absence of prospective, randomized, controlled clinical trial data as
support for the economic differentiation of balloon kyphoplasty over
vertebroplasty is causing some influential physicians in positions of authority
to speak out against adoption of balloon kyphoplasty, which may ultimately
adversely affect our business and our financial condition, which could cause our
stock price to decline.

Over the past year or so, a handful of vocal physicians have begun to
publicly criticize the cost and merits of balloon kyphoplasty as a procedure for
treating vertebral compression fractures.  We believe this is due, in part, to
the absence to-date of prospective, randomized, controlled clinical trial data
on the effectiveness of balloon kyphoplasty and the perceived economic cost
difference between balloon kyphoplasty and vertebroplasty.  On more than one
occasion, certain speakers, including a few physicians of authority in various
institutions and professional societies, have publicly stated their opposition
to both balloon kyphoplasty and Kyphon based on this lack of perceived
justification for the cost or economics of the procedure.  We have recently
completed enrollment in a randomized, controlled trial comparing balloon
kyphoplasty versus non-surgical management.  We do not yet know what clinical
outcomes that trial will reveal, or whether the trial's results, once available,
will demonstrate the benefits of treatment of vertebral compression fractures
with balloon kyphoplasty.  We also cannot predict how the current negative
public criticism to adoption of our products for treating patients ultimately
may affect our business or our revenues.

If primary care physicians are unwilling or unable to refer patients to
trained clinicians that use our KyphXproducts to perform balloon
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 spinal fracture treatment and conservative pain
management therapies.  We believe primary care is an important source of patient
referral, and, therefore, it is important to educate them about our products and
the clinical outcome of the balloon kyphoplasty procedure.  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 spinal 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 have continued referrals from primary care physicians, then
our future growth will be harmed and our business may decline.

If we are unable to successfully integrate into our business InnoSpine, Inc.
or any other acquisitions we may choose to make, we could encounter difficulties
that harm our business.

We recently acquired InnoSpine, Inc. and a technology that we have not dealt
with before.  We may also acquire other companies, products or technologies that
we believe to be complementary to the present or future direction of our
business.  We may have difficulty integrating the acquired personnel,
financials, operations, products or technologies into our existing business.
Acquisitions and the resulting integration may dilute our earnings per share,
harm our liquidity, disrupt our ongoing business, distract our management and
employees, increase our expenses, create an unfavorable impression of our
company in the public markets for our equity, and expose us to new risks and
liabilities, any or all of which could harm our business and cause our stock
price to decline.

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 KyphX 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 may already be introducing products to
directly compete with ours in similar procedures, both in the United States and
abroad, including, in some instances, copies of our technology for distribution
in one or more foreign markets.  Some of these competitors' products may be
successful as a result of greater efficacy, less expensive alternatives to our
products, or another 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 KyphX
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 address patient and surgeon requirements.  We compete with many
larger companies that enjoy competitive advantages, including:

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

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

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

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

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

The medical device industry has been characterized by extensive litigation
and administrative proceedings regarding patents and other intellectual property
rights.  Whether a medical device infringes a patent involves complex legal and
factual issues, the determination of which is often uncertain.  Our competitors
may assert that our instruments and methods infringe their patents, especially
as we expand our business into other areas of technology for diagnosis and
treatment of spinal conditions.  From time to time, we receive correspondence
from various third parties accusing us of infringing their patents or inviting
us to license their patents.  In addition, they may claim that their patents
have priority over ours because they invented first or their patents were filed
or issued first.  Because patent applications can take many years to issue,
there may be applications now pending of which we may be aware or unaware, which
may later result in issued patents that our instruments or methods may infringe.
There could also be existing patents that one or more of our instruments or
methods may inadvertently be infringing.  As the number of competitors in the
market for minimally invasive spine disorder treatments grow, the possibility of
a patent infringement claim against us increases.

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

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



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

Our failure to maintain necessary regulatory clearances or approvals, or
to obtain additional regulatory clearances or approvals, in the U.S. and abroad
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 conduct, our business.  Unless an exemption applies, each medical
device that we wish to market in the United States must first receive either
510(k) clearance or premarket approval from the FDA.  The FDA's 510(k) clearance
process usually takes from three to 12 months, but may take longer.  The
premarket approval process generally takes from one to three years from the time
the application is filed with the FDA, but it can take longer, require more
information, and be significantly more expensive than the 510(k) clearance
process.  So far, we have obtained 510(k) clearance for the KyphX
Inflatable Bone Tamps for fracture reduction or void creation in specific sites
including the spine (including for use during balloon kyphoplasty using our bone
cement), hand, tibia, radius and calcaneus, and clearance for our KyphX HV-
R Bone Cement for the treatment of pathological fractures of the vertebral
body due to osteoporosis, cancer, or benign lesions during balloon kyphoplasty
procedures.  These clearances allow us to promote numerous short- and long-term
clinical benefits associated with balloon kyphoplasty procedures.  We have also
procured CE marking for promoting our products in Europe and the appropriate
governmental regulatory clearances to conduct business in Canada and several
other foreign countries.  Nevertheless, our 510(k) and foreign regulatory
clearances can be revoked if safety or effectiveness problems develop.  We also
will be required to obtain 510(k) clearance or premarket approval and foreign
regulatory clearances to market additional products, such as new biomaterials
for use in balloon kyphoplasty, which will likely require clinical data, and to
market our existing products for new indications, such as treatment of fractures
caused by trauma, or in new geographic jurisdictions for us, such as Japan.  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
regulatory clearances or premarket approvals in a timely manner or at all, and
delays in obtaining clearances or approvals may adversely affect our revenue
growth, future profitability and ability to penetrate what otherwise might be
lucrative markets for our products.

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

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

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

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 could have excess capacity or
insufficient capacity, either of which could adversely affect our operating
results.

We currently manufacture substantially all of our KyphX instruments in
our facilities located in Sunnyvale, California.  We plan to expand our
manufacturing capacity at this facility.  In addition, we will be devoting
significant resources during 2006 and 2007 towards establishing our new
facilities in Neuchâtel, Switzerland that will include manufacturing
capacity.  We plan to manufacture a secondary supply of our KyphX
instruments in this facility, in addition to manufacturing our proprietary
KyphOs calcium phosphate and KyphX HV-Rbone cement.  We could
experience difficulties and disruptions in the manufacture of our KyphX
instruments during capacity expansion in our Sunnyvale facility, prior to
bringing up our Neuchâtel facility.  In both our Sunnyvale and
Neuchâtel facilities we could also face the inability to procure and
install the necessary manufacturing equipment, a shortage of components used in
our products, a lack of availability of qualified manufacturing personnel,
difficulties in achieving consistent quality control from new manufacturing
lines, difficulties in obtaining or maintaining compliance with regulatory
requirements mandated by the FDA and the European Union and an inability to
maintain sufficient manufacturing capacity.  We may experience delays,
disruptions, capacity constraints and other problems in our manufacturing
operations, and, as a result, product shipments to our customers could be
delayed, which would negatively impact our revenues, competitive position and
reputation.  If we are unable to expand our manufacturing capacity in a timely
manner, or if we do not accurately project demand, we will have excess capacity
or insufficient capacity, either of which could seriously harm our
profitability.

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

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

We are aware that a complaint, which we believe is a qui tam
complaint, is being evaluated by a U.S. Attorney's Office in connection with our
marketing and sales practices, including those relating to the Medicare
reimbursement available to our customer hospitals.  If a subpoena, or an
enforcement or other action ultimately results from this investigation, our
business and financial condition could be adversely affected which could cause
our stock price to decline.

We have learned that sometime in 2005, a U.S. Attorney's Office (USAO)
received a complaint that we believe is a qui tam complaint that alleges
impropriety in our reimbursement practices.  Although no subpoena has been issued to
us, the USAO in connection with this complaint is investigating our sales and
marketing practices, including those relating to Medicare reimbursement
available to our customer hospitals, based on site-of-service, for using
Kyphon's products in surgery, and has informally asked about some of our
documentation that may be relevant to the investigation.  We believe
we are in substantial compliance with the healthcare laws relevant to our
Company.  Even though we have not received a subpoena regarding the complaint
or its allegations, we are voluntarily cooperating with the USAO, to
permit the USAO to develop an informed opinion on whether or not to pursue any
action in connection with the complaint, although timing on that decision is
uncertain.  At this time, we do not know whether the outcome of the
investigation will have a material adverse impact to our business, and cannot
assure you regarding any future path USAO or any related lawsuit may take.  If
an enforcement or other action results from the ongoing investigation, our
business and financial condition could be adversely affected which could cause
our stock price to decline.

We derive a significant portion of our operating results from non-U.S. sales,
which are subject to additional risks arising from international operations and
sales.

Sales outside of the United States account for a significant percentage of
our revenues and we intend to continue to expand our presence in international
markets.  International net sales accounted for $48.5 million, or approximately
16% of total net sales in 2005.  Our international operations and sales are
subject to a number of further risks in addition to those faced for our
business, generally including:

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

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

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

With the present exception of Canada and some of the larger countries in
Europe, we sell our KyphX instruments in foreign markets through
distributors and sales agents.  To the extent we rely on distributors, our
success will depend upon the efforts of others, over which we may have little
control.  We recently terminated our relationship with distributors in several
foreign jurisdictions and are in the process of establishing, or have already
established, new relationships in those and other 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.  Alternative sales channels are available in
these geographic markets, however, their establishment could consume substantial
time and resources.

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 425 employees in December 2005, which we
believe represents significant growth over a relatively short period of time.
Our world-wide organization as a whole has increased from approximately 131
employees in October 2000 to over 880 employees in December 2005.  We intend to
continue growing rapidly.  The growth that we have experienced, and in the
future likely will experience, provides challenges to our organization,
requiring us to rapidly expand our personnel and manufacturing operations.  We
may not be able to hire sufficient personnel to meet our growth goals or may
have difficulty managing such rapid growth.  As a result, our failure to recruit
additional sales and other personnel may result in our inability to meet our
projections.  Future growth may strain our infrastructure, operations, product
development and other managerial and operating resources.  If our business
resources become strained, we may not be able to deliver instruments in a timely
manner.

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

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

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

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

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

As of December 31, 2005, we had $76.1 million of cash and cash equivalents
and $118.3 million of short-term investments.  We currently believe that our
current cash, cash equivalents, investments, and cash generated from operations
will be sufficient to meet our anticipated cash needs for at least the next 12
months.  If existing cash, cash equivalents, and cash generated from operations
are insufficient to satisfy our cash requirements, whether as a result of
possible investment in new markets or businesses through both internal or
external business development, expansion of product lines, increased capital
expenditures, additional clinical trials, expansion of product lines or
investment in new markets or businesses, or for other reasons related to our
business, we may seek to sell additional equity or debt securities or obtain a
credit facility.  The sale of additional equity or the sale of convertible debt
securities could result in dilution to our stockholders.  If additional funds
are raised through the issuance of debt securities, these securities could have
rights senior to those associated with our common stock, and could contain
covenants that would restrict our operations.  Additional financing may not be
available to us when we need it or it may not be available on favorable terms,
if at all.  If we are unable to obtain adequate financing when needed, we may
have to delay, reduce the scope of or eliminate our business development
activities.

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

Our basic corporate documents and Delaware law contain provisions that enable
our management to attempt to resist a takeover unless it is deemed by management
and our Board of Directors to be in the best interests of our stockholders.
Those provisions might discourage, delay or prevent a change in the control of
our company or a change in our management.  Our Board of Directors may also
choose to adopt further anti-takeover measures without stockholder approval.
The existence and adoption of these provisions could adversely affect the voting
power of holders of common stock and limit the price that investors might be
willing to pay in the future for shares of our common stock.

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

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

We can provide no assurance regarding our, or our independent auditor's,
conclusions after December 31, 2005 with respect to the effectiveness of our
internal control over financial reporting.

Section 404 of the Sarbanes-Oxley Act of 2002 requires us to include an
internal control report from management in our Annual Report on Form 10-K 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 expended significant resources in developing the necessary
documentation and testing procedures required by Section 404, given the risks
inherent in the operation of internal controls over financial reporting, we can
provide no assurance as to our, or our independent auditor's, conclusions after
December 31, 2005 with respect to the effectiveness of our internal control over
financial reporting.  Although we received unqualified opinions as of December
31, 2005, if we are unable to maintain compliance with all of the requirements
imposed by Section 404, or if we are unable to complete any assessment of our
internal controls, or if our internal controls are not designed or operating
effectively, we may conclude that our internal control over financial reporting
is not effective and our external auditors may either disclaim an opinion as it
relates to management's assessment of the effectiveness of our internal control
or may issue a qualified opinion on the effectiveness of our internal controls.
Investors may lose confidence in the reliability of our financial statements,
which could cause the market price of our common stock to decline and which
could affect our business and financial condition.

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 Statement of Financial Accounting Standards (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-based method and record
such expense in our consolidated financial statements.  We are required to
expense employee stock-based compensation awards beginning January 1, 2006.
Currently, we disclose such expenses on a pro forma basis in the notes to our
consolidated financial statements, but we do not record a charge for employee
stock option expense in the financial statements.  Once we begin to comply with
SFAS No. 123(R) as of the beginning of fiscal year 2006, our reported earnings
will decrease, which may affect our stock price.  In addition, our reported
earnings may have increased volatility due to the tax impact and timing of
employee stock option exercises.

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

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

A significant amount of our United States revenue is dependent on business
from areas prone to hurricanes, and the occurrence of one or more significant
hurricanes or other natural disasters in those geographic areas could
substantially adversely impact many of our customers' operations, which would
harm our financial condition and our revenues.

Many of our customers in the southeastern United States and the
Gulf Coast region have been adversely affected by one or more major hurricanes
during the past several years, and may be so affected in the future.  Such
catastrophic storm activity has in the past adversely affected our revenues
from, and business activities in, those regions, and could in the future
similarly adversely affect our revenues and operations, due to our customers'
decreased ability to continue their operations without significant disruption.
We may also be entering a historic period of increased hurricane activity.  If
any disaster of this sort were to occur in the future, our United States
revenues could be significantly impacted.

ITEM 1B.	UNRESOLVED STAFF
COMMENTS

None

ITEM 2.	PROPERTIES

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

Our European operations are located in an approximately 28,000
square feet 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.  In
November 2005, we entered into a two year lease for an approximately 16,000
square feet facility in Neuchâtel, Switzerland.  This lease will serve as
a temporary facility for us to conduct administrative and distribution
activities for our international business while we build a larger facility in
Neuchâtel.  We anticipate the larger facility should be available in 2007,
and are currently evaluating financing options for it.  We plan to conduct
manufacturing, distribution, administrative and certain research and development
activities in this facility to support the growth of our international business.

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

ITEM 3.	LEGAL PROCEEDINGS

In November 2005, Dr. Harvinder Sandhu, a well-respected orthopaedic surgeon,
and Kyphon filed suit in federal district court in Memphis, Tennessee against
Medtronic Sofamor Danek and several other related corporate entities seeking
compensatory and punitive damages and injunctive relief for breach of contract
and related covenants, trade secret theft, fraud, unjust enrichment, and
correction of inventorship of several patents and patent applications presently
owned by Sofamor Danek, including U.S. Patent No. 6,676,665.  The suit also
requests, among other relief, that Sofamor Danek transfer to Dr. Sandhu
ownership of the disputed patents and patent applications.  The dispute concerns
inventions related to an expandable, mechanical bone tamp for use in treating
vertebral compression fractures that Dr. Sandhu invented in the late 1990's and
which he confidentially disclosed and discussed with Sofamor Danek.  The
complaint alleges that Sofamor Danek later filed for several patents
encompassing and claiming Dr. Sandhu's inventions without naming him as inventor
of that technology and that it also incorporated Dr. Sandhu's inventions into
its internal Equestra project without his permission.  The litigation is
in its early stages; no trial date has yet been set.

From time to time, Kyphon may become involved in litigation relating to
additional claims arising from the ordinary course of business.  Management does
not know whether the final disposition of any such litigation matters will have
a material adverse affect on Kyphon.

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 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

Fiscal Year 2005                                                           
First quarter                                         $   28.47  $   23.86
Second quarter                                        $   34.79  $   24.28
Third quarter                                         $   44.93  $   34.06
Fourth quarter                                        $   46.40  $   37.76`

We had 98 stockholders of record as of February 15, 2006.  Since many
holders' shares are listed under their brokerage firm's name, we believe the
actual number of stockholders is greater than 98.

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.

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

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

ITEM 6.	SELECTED FINANCIAL DATA

The following tables contain selected consolidated financial data derived
from our consolidated financial statements for each of the last five years.  The
consolidated statement of operations data for the years ended December 31, 2005,
2004 and 2003, and the consolidated balance sheet data as of December 31, 2005
and 2004 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, 2002 and 2001, and the consolidated
balance sheet data as of December 31, 2003, 2002 and 2001 are derived from our
audited consolidated financial statements not included in this Annual Report on
Form 10-K.  Historical results are not necessarily indicative of future results.
The selected consolidated financial data set forth below should be read in
conjunction with our consolidated financial statements, the related notes and
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" included elsewhere in this Annual Report on Form 10-K.

`Year Ended December 31,
                                                      ----------------------------------------------------------
                                                         2005        2004        2003        2002        2001
                                                      ----------  ----------  ----------  ----------  ----------
                                                                (in thousands, except per share amounts)
Consolidated Statement of Operations Data:                                                                      
Net sales                                            $  306,082  $  213,414  $  131,028  $   76,316  $   36,073
Cost of goods sold                                       35,843      24,734      16,794      10,416       8,108
                                                      ----------  ----------  ----------  ----------  ----------
Gross profit                                            270,239     188,680     114,234      65,900      27,965
                                                      ----------  ----------  ----------  ----------  ----------
Operating expenses:
  Research and development                               46,383      22,238      16,031      22,512       7,978
  Sales and marketing                                   144,768     106,103      69,538      44,083      28,360
  General and administrative                             34,951      25,972      16,328      11,849       9,132
                                                      ----------  ----------  ----------  ----------  ----------
      Total operating expenses                          226,102     154,313     101,897      78,444      45,470
                                                      ----------  ----------  ----------  ----------  ----------
Income (loss) from operations                            44,137      34,367      12,337     (12,544)    (17,505)
Interest income (expense) and other, net                  3,979       1,250         986      (2,794)       (309)
                                                      ----------  ----------  ----------  ----------  ----------
Income (loss) before income taxes                        48,116      35,617      13,323     (15,338)    (17,814)
Provision (benefit) for income taxes                     18,280      13,900     (14,000)         --          --
                                                      ----------  ----------  ----------  ----------  ----------
Net income (loss)                                    $   29,836  $   21,717  $   27,323  $  (15,338) $  (17,814)
                                                      ==========  ==========  ==========  ==========  ==========

Net income (loss) per share:
  Basic                                              $     0.70  $     0.54  $     0.71  $    (0.63) $    (9.06)
  Diluted                                            $     0.66  $     0.50  $     0.65  $    (0.63) $    (9.06)
Weighted-average shares outstanding:
  Basic                                                  42,803      40,449      38,433      24,405       1,967
                                                      ==========  ==========  ==========  ==========  ==========
  Diluted                                                45,336      43,670      42,090      24,405       1,967
                                                      ==========  ==========  ==========  ==========  ==========

                                                                           As of December 31,
                                                      ----------------------------------------------------------
                                                         2005        2004        2003        2002        2001
                                                      ----------  ----------  ----------  ----------  ----------
                                                                            (in thousands)
Consolidated Balance Sheet Data:                                                                                
Cash, cash equivalents and investments               $  194,473  $  115,799  $   85,479  $   74,303  $    3,352
Working capital (deficit)                               216,504     153,926      86,564      83,504      (5,623)
Total assets                                            316,632     213,389     154,480     101,524      18,287
Convertible promissory notes                                 --          --          --          --      12,000
Long-term debt                                               --          --          --          --          43
Redeemable convertible preferred stock                       --          --          --          --      38,024
Deferred stock-based compensation                           116       2,113       6,435      11,947      16,082
Total stockholders' equity (deficit)                 $  250,056  $  179,635  $  134,250  $   91,514  $  (37,667)`



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

Introduction

Management's discussion and analysis of financial condition and results
of operations is organized as follows:

- Executive summary.
- Critical accounting policies and estimates.
- Results of operations.
- Stock-based compensation.
- Seasonality.
- Liquidity and capital resources.
- Recent accounting pronouncements.
- Factors affecting future operating results.

Executive Summary

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

Our corporate headquarters and United States operations are located in
Sunnyvale, California, where we conduct our manufacturing, warehousing, research
and development, regulatory and administrative activities.  Outside the United
States, we operate a sales, clinical, regulatory and administrative facility in
Brussels, Belgium, a research and biomaterials manufacturing facility in
Rosbach, Germany, a clinical, regulatory and administrative facility in Japan,
and we have direct selling operations in many of the major countries in Europe
and in Canada.  In November 2005, we leased a facility which serves as a
temporary facility for us to conduct administrative and distribution activities
for our international business while we build a larger facility in
Neuchâtel, Switzerland.  We anticipate the larger facility should be
available in 2007, and are currently evaluating financing options for it.  We
plan to conduct manufacturing, distribution, administrative and certain research
and development activities in this facility to support the growth of our
international business.  Our global distribution network consists of a direct
sales organization in excess of 425 individuals who market our products in the
U.S., many of the major countries in Europe and in Canada and distributors and
sales agents in other countries in which we do not have a direct sales force.
In Japan, we are presently focused primarily on procuring the appropriate
governmental regulatory clearances and approvals necessary to market and sell
our KyphX products, and we recently enrolled our sixth patient in our
Japanese clinical trial.

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, KyphX
Bone Biopsy Device, KyphX HV-R Bone Cement, KyphXMixer and our
CE-Marked KyphOs calcium phosphate from our acquisition of Sanatis GmbH
(Sanatis).

During 2005, our business experienced significant growth.  Net sales in 2005
increased to $306.1 million, compared to $213.4 million in 2004,
representing growth of 43%.  We trained over 2,200 physicians during 2005,
primarily in the United States and in Europe.  In the U.S., we added
approximately 286 new hospitals to our customer base during 2005.

In April 2005, we entered into an agreement to exclusively license, in the
field of orthopaedics including all spinal applications, Dr. J. Lee Berger's
portfolio of patents concerning medical devices and methods for creating voids
in, or moving, tissue or bone, including platform cannulae for expandable
bodies.  We made an up-front payment of $1.0 million in April 2005 and have
agreed to provide a lifetime-capped royalty stream on any products that may be
developed that practice the licensed patent rights.

In January 2006, we formed an exclusive consulting relationship with Dr.
Harvinder Sandhu, a well-respected orthopaedic surgeon, covering various fields
of minimally invasive spine diagnosis and therapy, including treatment of spinal
disc disorders and diagnosis of various spine conditions.  In November 2005, Dr.
Sandhu had previously agreed to exclusively license to Kyphon his early
invention rights concerning a directional bone tamp for treating vertebral
compression fractures for a cash payment of $5.0 million and a series of
payments totaling up to an additional $15.0 million.  The license also includes
a capped royalty stream on any future developed product that practices Dr.
Sandhu's technology.

On December 30, 2005, we entered into a definitive agreement to acquire
InnoSpine, Inc. (InnoSpine) a privately held company focused on developing and
marketing its proprietary technology platform for the diagnosis and potential
treatment of axial low back pain due to disc degeneration.  The terms of the
acquisition called for an initial purchase price of $2.5 million in cash to the
shareholders of InnoSpine, plus the possibility of up to an additional $27.5
million in cash or stock, based on achievement of clinical and other milestones
as well as royalties on future net sales.  We recorded $11.0 million to
developed technology as a result of this acquistion which we expect to amortize
on a straight line basis over the next 10 years.  We intend to initiate full
commercial launch of the InnoSpine product during the second quarter of 2006.
We expect that sales of the InnoSpine product will largely offset the associated
impact of increased operating expenses.

With our acquisition of InnoSpine, we have moved beyond only our original
sole focus of spinal deformity correction, through treatment of vertebral
compression fractures, to our second business focus, disc repair and
regeneration.  We have a variety of internal resources dedicated to supporting
research and development in this area as well as potential business development
opportunities.  Our third business focus, cancer therapy aimed at addressing the
actual cancerous conditions that affect the spine rather than merely the effects
of those cancerous conditions, such as vertebral compression fractures, remains
an area of interest for us and we continue to investigate how and when best to
enter that initiative.  We believe both additional business initiatives provide
further opportunity to grow our company in the area of minimally invasive spinal
diagnosis and therapies.

We will continue to evaluate other additional 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 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 such opportunities are
outside of the field for the treatment of spinal fractures or disease, or
outside of the spine itself.  Some of the opportunities we are presently
investigating include technologies and products that address degenerative disc
disease.  These efforts may require us to seek additional funding and may be
dilutive to our earnings.  And until such time, if ever, that Kyphon succeeds in
diversifying its business through internal development or external business
development activities, Kyphon will remain dependent on the single opportunity
of treating vertebral compression fractures with balloon kyphoplasty with its
products and bear the traditional risks to its business of being a company whose
revenues are principally derived from one procedure.

On February 6, 2006, Mr. Frank P.
Grillo joined the Company as our Vice President, Strategy and Business
Development, a newly established position.  Mr. Grillo most recently comes from
ten years at Boston Scientific Corporation where he most recently held the
position of Vice President, Marketing, Women's Health, Urology/Gynecology
Division.  Prior to his role in Marketing, Mr. Grillo spent four years as
Director of New Business Development for the cardiology and drug delivery groups
at Boston Scientific.  Mr. Grillo has an MBA from the J.L. Kellogg Graduate
School of Business at Northwestern University and a Bachelor of Science in
Chemical Engineering from Tufts University.   In his role, Mr. Grillo
will report to Mr. Richard W. Mott, our President & Chief Executive
Officer.

Effective February 15, 2006, Arthur T. Taylor, the Company's Vice President,
Chief Financial Officer and Treasurer (CFO) since August 2004, was promoted to
assume the responsibility of Chief Operating Officer (COO), a newly established
position, for the Company.  Mr. Taylor will also continue to serve as CFO in the
interim until an appropriate successor is hired.  As our COO, Mr. Taylor will
continue to report to Mr. Mott, and will oversee our manufacturing, quality,
research and development, reimbursement, product marketing, clinical and
regulatory, and information systems and technology departments.

Also effective February 15, 2006, Ms. Elizabeth A. Rothwell, who previously
served as our Vice President, Operations and Quality from February 2003 until
March 2005, and who temporarily assumed the role of Vice President, Research and
Development in April 2005, will now reassume the role of Vice President,
Quality, and Mr. Rick S. Kline, who has served as our Vice President, Operations
and Quality since April 2005, will continue to serve as our Vice President,
Operations.  Both Ms. Rothwell and Mr. Kline will report to Mr. Taylor as COO.
The Company intends to promptly begin a search to fill the roles of Vice
President, Research and Development, and Vice President and CFO.



Over the past year, a handful of vocal physicians have begun to publicly
criticize the cost and merits of balloon kyphoplasty as a procedure for treating
vertebral compression fractures.  We believe this is due, in part, to the
absence to-date of prospective, randomized, controlled clinical trial data to
justify the effectiveness of balloon kyphoplasty and the perceived economic
differentiation between balloon kyphoplasty and vertebroplasty.  On more than
one occasion, certain speakers, including a few physicians of authority in
various institutions and professional societies, have publicly stated their
opposition to both balloon kyphoplasty and Kyphon based on a lack of perceived
justification for the cost or economics of the procedure.  While we are in the
process of conducting a randomized, controlled trial in Europe comparing balloon
kyphoplasty versus non-surgical management, enrollment of which recently
concluded, we do not yet know what clinical outcomes that trial will reveal, or
whether the trial's results, once available, will be beneficial to making a case
for treatment of vertebral compression fractures with balloon kyphoplasty, or
how this public negative criticism to adoption of our products for treating
patients ultimately may affect our business or our revenues.

The status of our significant current clinical trials
follows:



- We secured approval from the Japanese Ministry of Health to begin our
clinical trial in the third quarter of 2005.  Our Japanese trial is a single arm
study that will enroll a total of 81 patients with spinal fractures and follow
them for 2 years.  Patient enrollment is presently expected to conclude in 2006.
Data from this trial, in addition to clinical data obtained from studies
previously completed in the US and Europe, will be used to support regulatory
approval in Japan for balloon kyphoplasty.  If approved, we could begin
commercialization in Japan in the 2009 timeframe.



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

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

Significant Industry Factors.  Our industry is impacted by
numerous competitive, regulatory and other significant factors.  The growth of
our business relies on our ability to continue to develop new products and
innovative technologies, obtain regulatory clearances and compliance for our
products, protect the proprietary technology of our products and our
manufacturing processes, manufacture our products cost-effectively, and
successfully market and distribute our products in a profitable manner.  We, and
the entire industry, are subject to extensive government regulation, including
the United States Food and Drug Administration (FDA).  Failure to comply with
regulatory requirements could adversely affect our business and our financial
condition, which could cause our stock price to decline.  Additionally, our
industry is highly competitive and our success depends on our ability to compete
successfully.  A detailed discussion of these and other factors is provided in
the "Factors Affecting Future Operating Results" section below.

Critical Accounting Policies and Estimates

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

Revenue recognition.

Accounts receivable allowances.  We make estimates on the
collectibility of customer accounts based primarily on analysis of historical
trends and experience and changes in customers' financial condition.  Management
uses its best judgment, based on the best available facts and circumstances, and
records a reserve against the amounts due to reduce the receivable to the amount
that is expected to be collected.  These reserves are reevaluated and adjusted
as additional information is received that impacts the amount reserved.  Our
accounts receivable allowances have been less than 1% of net sales for each of
the years ended December 31, 2005, 2004 and 2003.

Our accounts receivable balance was $55.5 million and
$42.3 million, net of allowances of $1.6 million and $1.1 million at
December 31, 2005 and 2004, respectively.

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

Our reserve for excess and obsolete inventories was $991,000 and $529,000 at
December 31, 2005 and 2004, respectively.

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

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.  Prior to the fourth quarter of 2003 we had provided a full
valuation allowance 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.

As part of the process of preparing our consolidated financial statements, we
are required to determine our income taxes.  This process involves determining
our actual current tax exposure together with assessing temporary differences
that may result in deferred tax assets.  Management judgment is required in
determining any valuation allowance recorded against our deferred tax assets.
Any such valuation allowance would be based on objective positive evidences and
the period over which our deferred tax assets would be recoverable.  As of
December 31, 2005 and 2004, we have recorded no valuation allowance, based on
our belief that it is more likely than not that we will be able to utilize our
deferred tax assets before they expire.

Purchase accounting.  Purchase accounting requires extensive
accounting estimates and judgments to allocate the purchase price between in-process
research and development, other identifiable intangible assets, tangible
assets, and goodwill as required by generally accepted accounting principles in
the United States.  To assist in determining the value of any in-process
research and development and certain other intangibles, a third party valuation
is typically obtained as of the acquisition date.  Purchased in-process research
and development is defined as the value assigned to those projects for which the
related products have not received regulatory approval 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 standard valuation
methods.  For purchased in-process research and development, these methodologies
include consideration of the risk of the project not achieving commercial
feasibility.

Goodwill and Impairment of long-lived assets.

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

Stock Option Valuation.

As of January 1, 2006, using the modified prospective method, we
adopted Statement of Financial Accounting Standards (SFAS) No. 123(R), which
requires the expensing of our stock compensation programs.  The adoption of SFAS
No. 123 (R) is expected to increase our cost of goods sold and operating
expenses by approximately $30.0 million in 2006 based upon employee stock
options outstanding as of December 31, 2005 and estimated 2006 option grants to
employees.  Had we been required to expense employee stock options in 2005, our
cost of goods sold and operating expenses would have increased by approximately
$25.3 million.

Results of Operations

Comparison of years ended December 31, 2005, 2004 and 2003

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

`Year Ended December 31,
                                                    ------------------------------------------------------------------
                                                             2005                   2004                   2003
                                                    --------------------   --------------------   --------------------
                                                                 % of                   % of                   % of
                                                     Amount    Net sales    Amount    Net sales    Amount    Net sales
                                                    ---------  ---------   ---------  ---------   ---------  --------- 
U.S. net sales                                     $ 257,558         84 % $ 187,526         88 % $ 118,422         90 %
International net sales                               48,524         16 %    25,888         12 %    12,606         10 %
                                                    ---------  ---------   ---------  ---------   ---------  ---------
Net sales                                            306,082        100 %   213,414        100 %   131,028        100 %
Cost of goods sold                                    35,843         12 %    24,734         12 %    16,794         13 %
                                                    ---------  ---------   ---------  ---------   ---------  ---------

Gross profit                                         270,239         88 %   188,680         88 %   114,234         87 %
                                                    ---------  ---------   ---------  ---------   ---------  ---------

Operating expenses:
  Research and development                            46,383         15 %    22,238         10 %    16,031         13 %
  Sales and marketing                                144,768         47 %   106,103         50 %    69,538         53 %
  General and administrative                          34,951         12 %    25,972         12 %    16,328         12 %
                                                    ---------  ---------   ---------  ---------   ---------  ---------
      Total operating expenses                       226,102         74 %   154,313         72 %   101,897         78 %
                                                    ---------  ---------   ---------  ---------   ---------  ---------

Income from operations                                44,137         14 %    34,367         16 %    12,337          9 %
Interest income and other, net                         3,979          2 %     1,250          1 %       986          1 %
                                                    ---------  ---------   ---------  ---------   ---------  ---------

Income before income taxes                            48,116         16 %    35,617         17 %    13,323         10 %
Provision (benefit) for income taxes                  18,280          6 %    13,900          7 %   (14,000)       (11)%
                                                    ---------  ---------   ---------  ---------   ---------  ---------
Net income                                         $  29,836         10 % $  21,717         10 % $  27,323         21 %
                                                    =========  =========   =========  =========   =========  =========`

Net Sales. Net sales increased $92.7 million, or 43%, in 2005
compared to 2004, and increased $82.4 million, or 63%, in 2004 compared to 2003.
The increases in net sales in 2005 primarily resulted from an increase in the
number of physicians trained in the use of our KyphX instruments as well
as an 18% increase in the number of procedures performed by trained physicians
per month compared to 2004.  During 2005 approximately 2,200 physicians were
trained in the use of our KyphX instruments.  The increases in net sales
in 2004 primarily resulted from the 1,700 more physicians trained in the use of
our KyphX instruments during 2004 as well as a 17% increase in the number
of procedures performed by trained physicians per month compared to 2003.
Domestic sales increased $70.0 million, or 37% in 2005 compared to 2004 and
$69.1 million, or 58% in 2004 compared to 2003.  International sales increased
$22.6 million, or 87% in 2005 compared to 2004 and $13.3 million, or 105% in
2004 compared to 2003.  International sales also reflected the unfavorable
currency impact of $0.5 million in 2005 and a favorable currency impact of $2.6
million in 2004 based on prior year's average Euro rates.  No customer accounted
for more than 10% of total net sales in 2005, 2004 or 2003.  As of December 31,
2005, we had trained approximately 5,000 spine specialists in the U.S. and
approximately 3,000 clinicians in other parts of the world, primarily Europe.
These physicians have used our KyphX instruments in approximately 187,000
patients and 220,000 spinal fractures worldwide.  We believe the total number of
potential physicians who may perform balloon kyphoplasty procedures using our
products is approximately 11,000 in the U.S.  Internationally, the number of
physicians who may perform balloon kyphoplasty is not as well-defined, but we
believe it to be more than 10,000.  We have targeted a range of $383 million to
$398 million in net sales for 2006.

Cost of Goods Sold. Cost of goods sold consists of material,
labor, subcontract, and overhead costs.  Cost of goods sold increased $11.1
million, or 45%, in 2005 compared to 2004, and increased $7.9 million, or 47%,
in 2004 compared to 2003.  The absolute increase in cost of goods sold over the
years from 2003 to 2005 resulted primarily from increased material, labor,
subcontract and overhead costs in relation to the increased sales volume of our
products in addition to an increase in our inventory provisions in fiscal 2005
and 2003 due to planned new generation product transition.  The cost of goods
sold as a percentage of net sales decreased from 2003 to 2004 primarily as a
result of fixed overhead costs being spread over increased production volume.
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.  As a percentage of net
sales, we expect cost of goods sold to be in the range of 12% to 13% for
2006.

Research and Development.  Research and development expenses
consist of costs for product research, product development, clinical functions
and outside costs related to clinical trials and personnel.  Research and
development expenses increased $24.1 million, or 109%, in 2005 compared to 2004.
Research and development expenses increased $6.2 million, or 39%, in 2004
compared to 2003.  The increase in 2005 from 2004 was primarily attributable to
the license acquisition charges of $20.0 million to Dr. Harvinder Sandhu and
$1.0 million to Dr. Lee Berger.  The remaining increase of $3.1 million was
attributable to increased personnel costs of $2.3 million, increased clinical
studies expense of $1.3 million, increased engineering and lab expenses of
$611,000, increased travel expenses of $604,000, and increased facilities costs
of $576,000, offset by a decreased research and development consulting fees of
$1.4 million and decreased educational grants of $990,000.  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
$655,000, offset by a decrease in amortization of deferred stock-based
compensation expense of $1.1 million.  We expect to continue to make substantial
investments in research and development and anticipate that research and
development expenses in 2006 will increase in absolute dollars excluding the
license acquisition charges due largely to the commencement of clinical studies.
We anticipate conducting significant additional clinical trial activity both in
the United States and abroad to collect further data that may support the use
and clinical efficacy of our products.  As a percentage of net sales, we
anticipate our research and development expenses to be in the range of 10% to
11% for 2006.

Sales and Marketing.  Sales and marketing expenses consist of
costs for personnel, physician training programs and marketing activities.
Sales and marketing expenses increased $38.7 million, or 36%, in 2005 compared
to 2004.  Sales and marketing expenses increased $36.6 million, or 53%, in 2004
compared to 2003.  The increase in 2005 from 2004 related primarily to a $28.3
million increase in the costs of hiring, training and compensating additional
direct selling representatives, increased advertising, trade shows, educational
and promotional activity expenses of $3.5 million, increased sales and marketing
travel expenses of $3.1 million, increased facilities expenses of $1.6 million
and increased educational grants of $1.1 million. 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 (SES) 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.  In 2005, we largely completed the
consolidation of the SES sales force with the rest of the sales force.  As we
continue to commercialize our KyphX instruments on a global basis, 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 net sales at 47% to 48% for 2006.

General and Administrative.  General and administrative
expenses consist of costs for personnel, professional service fees, expenses
related to intellectual property rights, Sarbanes-Oxley compliance and general
corporate expenses.  General and administrative expenses increased $9.0 million,
or 35%, in 2005 compared to 2004.  General and administrative expenses increased
$9.6 million, or 59%, in 2004 compared to 2003.  The increase in 2005 from 2004
was primarily attributable to increased consulting and outside professional
service fees of $3.7 million, increased personnel costs of $3.0 million, and
increased litigation costs of $1.3 million.  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.  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, and incur start-up costs for our new facility in
Switzerland.  Therefore, we anticipate that our general and administrative
expenses will increase in absolute dollars as we expand our infrastructure.  As
a percentage of net sales, we expect that our general and administrative
expenses will be approximately 14% to 15% in 2006.

Interest Income and Other, Net.  Interest income and other,
net, increased $2.7 million in 2005 compared to 2004.  Interest income and
other, net, increased $264,000 in 2004 compared to 2003.  The increase in 2005
compared to 2004, and the increase in 2004 compared to 2003 resulted primarily
from an increase in interest income due to higher cash, cash equivalents and
investment balances, as well as higher interest rates.  Our cash, cash
equivalents and investments balances were $194.5 million, $115.8 million, and
$85.5 million as of December 31, 2005, 2004, and 2003, respectively.

Provision (Benefit) for
Income Taxes.

At December 31, 2005, we had approximately $500,000 and $4.8 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 2023 and 2010, respectively, in each case if not utilized.

At December 31, 2005, we had research and development tax credit
carryforwards of approximately $2.2 million and $3.6 million for federal and
state income tax purposes, respectively.  If not utilized, the federal research
and development tax credit carryforwards will expire beginning in 2018.  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 for the Company, as defined, occurred
on August 8, 1996, December 14, 1999 and May 17, 2002.  In addition, we entered
into a definitive agreement to acquire InnoSpine on December 30, 2005.
Ownership changes for InnoSpine as defined, occurred on March 16, 2004 and
December 30, 2005.  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.

Stock-Based Compensation

We recorded deferred stock-based compensation on options issued prior to
our initial public offering 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 as the options vest, generally over four
years.  Deferred stock-based compensation for employee stock options recorded
through December 31, 2005 was $18.3 million, with accumulated amortization of
$18.2 million.  The remaining amount will be fully amortized by May 2006.  All
option amounts are being amortized using the straight-line method.

Stock-based compensation expense for stock options granted to non-employees
is recognized as the stock options are earned.  The stock-based compensation
expense will fluctuate as the fair market value of our common stock fluctuates.
In connection with the grant of stock options to non-employees, we recorded
stock-based compensation expense of approximately $1.3 million, $929,000 and
$1.9 million in 2005, 2004 and 2003, 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, 2005, we had $76.1 million of cash and cash equivalents,
$118.3 million of short-term investments, and working capital of $216.5 million.
Our cash and cash equivalents and investments increased by $78.7 million during
2005.

Cash Provided by Operating Activities.  Our operating cash flow
in 2005 was primarily the result of our operational profitability.  Net cash
provided by operations was $67.9 million attributable primarily to net income of
$29.8 million and adjustments for non-cash charges related to the provision for
deferred taxes including tax benefits from stock options of $14.8 million.  Net
cash provided by operations in 2004 was $31.0 million in 2004 attributable
primarily to net income of $21.7 million and adjustments for non-cash charges
related to the provision for deferred taxes including tax benefits from stock
options of $12.8 million.  Net cash provided by operations in 2003 was $13.0
million primarily attributable to net income of $27.3 million and offset by the
net release of the valuation allowance against our deferred tax assets of $18.1
million.



The increases in cash provided by operating activities for all periods was
adjusted by changes in our working capital, primarily in accounts receivable,
inventories and accrued liabilities.  Accounts receivable increased by $16.4
million, $17.6 million and $11.1 million during 2005, 2004, and 2003,
respectively, due to increases in our net sales. Inventories decreased by
$552,000 in 2005 due to improved inventory management.  Inventories increased by
$5.1 million and $2.4 million during 2004 and 2003, respectively, to meet the
increased demand for our products.  Accrued liabilities increased by $25.5
million, $9.0 million, and $7.0 million during 2005, 2004, and 2003,
respectively, due to our increased operating expenses and income taxes.  In 2005
accrued liabilities included $15.0 million relating to the license acquisition
charge from our agreement with Dr. Sandhu.

Cash Used in Investing Activities.  Net cash used in investing
activities was $100.9 million, $11.2 million and $13.3 million in 2005, 2004 and
2003, respectively.  Cash used in investing activities reflected purchases of
property and equipment for all periods.  During 2005, cash used for investing
activities reflected the net purchases of investments of $90.4 million, and
payment of $2.4 million in connection with the acquisition of InnoSpine.  During
2004, cash used in investing activities reflected the net purchases of
investments of $1.6 million.  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.   We expect our purchases of
property and equipment in 2006 to increase due to the expansion of our Sunnyvale
facility and the establishment of our new manufacturing, distribution and
research and development facilities in Switzerland.

Cash Provided by Financing Activities.  Net cash provided by
financing activities was $22.3 million, $9.8 million and $6.6 million in 2005,
2004 and 2003, respectively.  Cash provided during 2005 was attributable to
proceeds from the issuance of common stock under the employee stock purchase
plan of $4.7 million and the exercise of stock options of $17.6 million.  Cash
provided during 2004 was attributable to proceeds from the issuance of common
stock under the employee stock purchase plan of $3.4 million and the exercise of
stock options of $6.4 million.  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.

Contractual Cash Obligations. At December 31, 2005 we had
contractual cash obligations as follows (in thousands):

`Payment Due by Periods
                                                   ------------------------------------------------------
                                                     Total      2006     2007-2008   2009-2010  After 2010
                                                   ---------  ---------  ----------  ---------  ---------
Operating leases                                  $  24,439  $   3,178  $    6,140  $   5,629  $   9,492
Consulting agreement                                    200         75         125         --         --
License agreement                                    15,000      5,000      10,000         --         --
Purchase commitments with contract
   manufactures and suppliers                         6,697      6,697          --         --         --
Purchase obligations                                  7,470      7,470          --         --         --
Asset retirement obligation                             441         --          --         --        441
                                                   ---------  ---------  ----------  ---------  ---------
Total commitments                                 $  54,247  $  22,420  $   16,265  $   5,629  $   9,933
                                                   =========  =========  ==========  =========  =========`

The amounts reflected in the table above for operating leases represent
aggregate future minimum lease payments under non-cancellable facility leases.
Portions of these payments and a portion of the asset retirement obligations are
denominated in foreign currencies and were translated in the tables above based
on their respective U.S. dollar exchange rates at December 31, 2005.  These
future payments are subject to foreign currency exchange rate risk.

We are obligated to make a series of annual payments totaling up to $15.0
million related to the license acquisition agreement with Dr. Sandhu.  The
payments of these additional obligations may be accelerated upon defined events
and circumstances or may be forgiven upon the occurrence of a third party event,
outside the control of the Company.  Based on management judgment, ability and
intent, this amount has been classified as current liability as of December 31,
2005.

On December 30, 2005, we entered into a definitive agreement to acquire
InnoSpine, Inc. a privately held company focused on developing and marketing its
proprietary technology platform for the diagnosis and potential treatment of
axial low back pain due to disc degeneration.  The terms of the acquisition
called for an initial purchase price of $2.5 million in cash to the shareholders
of InnoSpine, plus the possibility of up to an additional $27.5 million in cash
or stock, based on achievement of clinical and other milestones as well as
royalties on future net sales. This contingent purchase price liability is not
included in the table above.

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

Purchase Obligations.

Off-Balance Sheet Arrangements.  We do not have any off-balance
sheet financing as of December 31, 2005.  All of our subsidiaries are included
in the financial statements, and we do not have relationships with any special
purpose entities.

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

Summary.  We believe our 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.  We anticipate conducting
significant additional clinical trial activity both in the United States and
abroad to collect further data that may support the use and clinical efficacy of
our products.  The costs of these trials will be significant.  If existing cash,
cash equivalents, and cash generated from operations are insufficient to satisfy
our liquidity requirements, whether as a result of investment in new markets or
businesses through both internal or external business development, expansion of
product lines, additional clinical trials, possible increased capital
expenditures, or for other reasons related to our business, we may seek to sell
additional equity 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 adequate
financing when needed, we may have to delay, reduce the scope of, or eliminate
certain of our business expansion activities.

Recent Accounting Pronouncements

In November 2004, the Financial Accounting Standards Board
(FASB) issued SFAS No. 151, "Inventory Costs, an amendment of
Accounting Principles Board (APB) Opinion No. 43, Chapter 4."
SFAS No. 151 amends APB No. 43, Chapter 4, to clarify those abnormal
amounts of idle facility expense, freight, handling costs, and wasted material
(spoilage) should be recognized as current period charges.  In addition,
SFAS No. 151 requires that allocation of fixed production overhead to the cost
of conversion be based on the normal capacity of the production facilities.  The
provisions of SFAS No. 151 are effective for fiscal years beginning after June
15, 2005.  Accordingly, the provisions of SFAS No. 151 will be effective January
1, 2006 for us.  The adoption of SFAS No. 151 is not expected to have a material
impact on our consolidated financial statements.

In December 2004, the FASB originally issued SFAS No. 123(R).  SFAS No.
123(R) will require companies to measure all stock-based compensation awards
using a fair value-based method and record such expense in their 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), as amended,
is effective for public companies for the first annual period beginning after
June 15, 2005.  Accordingly, the provisions of SFAS No. 123(R) will be effective
January 1, 2006 for us.  In March 2005, the SEC issued Staff Accounting Bulletin
(SAB) No. 107, "TOPIC 14: Share-based payment."  SAB No. 107 addresses
the interaction between SFAS No. 123(R) and certain SEC rules and regulations
and provides views regarding the valuation of share-based payment arrangements
for public companies.  SAB No. 107 was effective immediately.

We plan to adopt SFAS No. 123(R) using the modified prospective
method, under which compensation cost is recognized beginning with the effective
date (a) based on the requirements of SFAS No.123(R) for all share-based
payments granted after the effective date and (b) based on the previous
requirements of SFAS 123 for all awards granted to employees prior to the
effective date of SFAS No. 123(R) that remain unvested on the effective date.
The amounts disclosed within our consolidated financial statement footnotes are
not necessarily indicative of the amounts that will be expensed upon the
adoption of SFAS No. 123(R).  Compensation expense calculated under SFAS No.
123(R) may differ from amounts currently disclosed within our consolidated
financial statement footnotes based on changes in the fair value of our common
stock, changes in the number of options granted or the terms of such options,
the treatment of tax benefits and changes in interest rates or other factors.
The adoption of SFAS No. 123 (R) is
expected to increase our cost of goods sold and operating expenses by
approximately $30.0 million in 2006 based upon employee stock options
outstanding as of December 31, 2005 and estimated 2006 option grants to
employees. We expect the
adoption of SFAS 123 (R) to have a significant impact on our consolidated income
statements and the presentation of the consolidated statements of cash
flows.

In March 2005, the FASB issued FASB Interpretation No. 47 (FIN
No. 47), "Accounting for Conditional Retirement Obligations-an
interpretation of SFAS No. 143."  FIN No. 47 clarifies the timing of
when a liability should be recognized for legal obligations associated with the
retirement of a tangible long-lived asset.  In addition, FIN No. 47 clarifies
the treatment when there is insufficient information to reasonably estimate the
fair value of an asset retirement obligation.  FIN No. 47 is effective no
later than December 31, 2005.  Retrospective application for interim
financial information is permitted but is not required.  The adoption of FIN No.
47 did not have a material impact on our consolidated financial statements.

In June 2005, the Emerging Issues Task Force (EITF) reached a consensus
on Issue No. 05-6 (EITF No. 05-6), "Determining the Amortization
Period for Leasehold Improvements Purchased after Lease Inception or Acquired in
a Business Combination."  EITF No. 05-6 clarifies that the amortization
period for leasehold improvements acquired in a business combination or placed
in service significantly after and not contemplated at or near the beginning of
the lease term should be amortized over the shorter of the useful life of the
assets or a term that includes the required lease periods and renewals that are
reasonably assured of exercise at the time of the acquisition.  EITF No. 05-6 is
to be applied prospectively to leasehold improvements purchased or acquired in
reporting periods beginning after June 29, 2005.  The adoption of EITF No.
05-6 did not have a material impact on our consolidated financial
statements.

ITEM 7A.   QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Our exposure to interest rate risk at December 31, 2005 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 84%, 88%, and 90% of our
sales were made in U.S. dollars in 2005, 2004, and 2003, respectively.  The
majority of our non-U.S. sales are derived from European Union countries and
denominated in the Euro.  Monthly income and expense from our European
operations are translated using average rates and balance sheets are translated
using month end rates.  Differences are recorded within stockholders' equity as
a component of accumulated other comprehensive income or to the income
statement, as applicable.  As our revenues denominated in currencies other than
the dollar increase, we have an increased exposure to foreign currency rate
risk. Based on our overall exposure for foreign currency at December 31, 2005, a
hypothetical 10% change in foreign currency rates would not have a material
impact on our net sales and operating expenses.  We may elect to mitigate this
rate risk, in part or in whole, through the purchase of forward currency
contracts.

ITEM 8.	FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA



REPORTS OF MANAGEMENT

Statement of Management's Responsibility

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

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

Management's Report on Internal Control Over Financial
Reporting

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

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

Management (with the participation of the principal executive officer and
principal financial officer) conducted an evaluation of the effectiveness of
Kyphon's internal control over financial reporting based on the framework in
Internal Control-Integrated Framework issued by the Committee of
Sponsoring Organizations of the Treadway Commission.  Based on this evaluation,
management concluded that Kyphon's internal control over financial reporting was
effective as of December 31, 2005.  Management's assessment of the
effectiveness of Kyphon's internal control over financial reporting as of
December 31, 2005 has been audited by PricewaterhouseCoopers LLP, an independent
registered public accounting firm, as stated in their report which is included
herein.



|KYPHON INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS                                                        
|--------------------------------------------------------------------------------------------------------------
|                                                                                                              
|Consolidated Financial Statements:                                                                            
|Report of Independent Registered Public Accounting Firm                                                       
|Consolidated
Statements of Operations for the years ended December 31, 2005, 2004 and
2003                    
|Consolidated Balance
Sheets at December 31, 2005 and 2004                                                     
|Consolidated
Statements of Cash Flows for the years ended December 31, 2005, 2004 and
2003                    
|Consolidated
Statements of Stockholder's Equity (Deficit) for the years ended December
31, 2005, 2004 and 2003
|Notes to
Consolidated Financial Statements                                                                    
|                                                                                                              
|Financial Statement Schedule:                                                                                 
|Schedule II
Valuation and Qualifying Accounts                                                                 

---



Report of Independent Registered Public Accounting Firm

To the Board of Directors and 
Stockholders of Kyphon Inc.: 
We have completed integrated audits of Kyphon Inc.'s 2005 and 2004
consolidated financial statements and of its internal control over financial
reporting as of December 31, 2005, and an audit of its 2003 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, 2005 and 2004, and the results
of their operations and their cash flows for each of the three years in the
period ended December 31, 2005 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, 2005 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, 2005, based on criteria established in Internal Control -
Integrated Framework issued by the COSO.  The Company's management is
responsible for maintaining effective internal control over financial reporting
and for its assessment of the effectiveness of internal control over financial
reporting. Our responsibility is to express opinions on management's assessment
and on the effectiveness of the Company's internal control over financial
reporting based on our audit.  We conducted our audit of internal control over
financial reporting in accordance with the standards of the Public Company
Accounting Oversight Board (United States).  Those standards require that we
plan and perform the audit to obtain reasonable assurance about whether
effective internal control over financial reporting was maintained in all
material respects.  An audit of internal control over financial reporting
includes obtaining an understanding of internal control over financial
reporting, evaluating management's assessment, testing and evaluating the design
and operating effectiveness of internal control, and performing such other
procedures as we consider necessary in the circumstances.  We believe that our
audit provides a reasonable basis for our opinions. 
A company's internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles.  A company's internal
control over financial reporting includes those policies and procedures that (i)
pertain to the maintenance of records that, in reasonable detail, accurately and
fairly reflect the transactions and dispositions of the assets of the company;
(ii) provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of
the company; and (iii) provide reasonable assurance regarding prevention or
timely detection of unauthorized acquisition, use, or disposition of the
company's assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting
may not prevent or detect misstatements.  Also, projections of any
evaluation of effectiveness to future periods are subject to the risk that
controls may become inadequate because of changes in conditions, or that the
degree of compliance with the policies or procedures may deteriorate. 
PricewaterhouseCoopers LLP 
San Jose, California 
February 28, 2006

---



Kyphon Inc.
                     Consolidated Statements of Operations 
                    (in thousands, except share and per share amounts)

`Year Ended December 31,
                                                     ----------------------------------
                                                        2005        2004        2003
                                                     ----------  ----------  ----------
Net sales                                           $  306,082  $  213,414  $  131,028
Cost of goods sold                                      35,843      24,734      16,794
                                                     ----------  ----------  ----------

Gross profit                                           270,239     188,680     114,234
                                                     ----------  ----------  ----------

Operating expenses:
  Research and development                              46,383      22,238      16,031
  Sales and marketing                                  144,768     106,103      69,538
  General and administrative                            34,951      25,972      16,328
                                                     ----------  ----------  ----------
      Total operating expenses                         226,102     154,313     101,897
                                                     ----------  ----------  ----------

Income from operations                                  44,137      34,367      12,337
Interest income                                          3,998       1,314       1,067
Other expense, net                                         (19)        (64)        (81)
                                                     ----------  ----------  ----------

Income before income taxes                              48,116      35,617      13,323
Provision (benefit) for income taxes                    18,280      13,900     (14,000)
                                                     ----------  ----------  ----------
Net income                                          $   29,836  $   21,717  $   27,323
                                                     ==========  ==========  ==========

Net income per share:
  Basic                                             $     0.70  $     0.54  $     0.71
                                                     ==========  ==========  ==========
  Diluted                                           $     0.66  $     0.50  $     0.65
                                                     ==========  ==========  ==========

Weighted-average shares outstanding:
  Basic                                                42,803      40,449       38,433
                                                     ==========  ==========  ==========
  Diluted                                              45,336      43,670       42,090
                                                     ==========  ==========  ==========`

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,
                                                                      ----------------------
                                                                         2005        2004
                                                                      ----------  ----------
Assets                                                                                      
Current assets:
  Cash and cash equivalents                                          $   76,149  $   87,236
  Investments                                                           118,324      24,421
  Accounts receivable, net of allowances of $1,577 in 2005
    and $1,054 in 2004                                                   55,480      42,347
  Inventories                                                             9,265      11,457
  Prepaid expenses and other current assets                               5,899       4,521
  Deferred tax assets                                                    10,488      13,537
                                                                      ----------  ----------
      Total current assets                                              275,605     183,519

Investments                                                                  --       4,142
Property and equipment, net                                              15,977      12,728
Goodwill and other intangible assets, less accumulated
   amortization of $88 in 2005 and $65 in 2004                           15,377       5,039
Deferred tax assets                                                       6,749       4,009
Other assets                                                              2,924       3,952
                                                                      ----------  ----------

      Total assets                                                   $  316,632  $  213,389
                                                                      ==========  ==========

Liabilities and Stockholders' Equity                                                        
Current liabilities:
  Accounts payable                                                   $    9,308  $    5,544
  Accrued liabilities                                                    49,793      24,049
                                                                      ----------  ----------
      Total current liabilities                                          59,101      29,593
                                                                      ----------  ----------

Deferred rent and other                                                   4,051       4,161
Contingent purchase price                                                 3,424          --
                                                                      ----------  ----------
      Total liabilities                                                  66,576      33,754
                                                                      ----------  ----------

Commitments and contingencies (Notes 4 and 6)

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: 43,843 shares in 2005 and 41,355 shares in 2004
    Outstanding: 43,813 shares in 2005 and 41,325 shares in 2004             44          41
  Additional paid-in capital                                            231,312     189,410
  Treasury stock, at cost: 30 shares in 2005 and 2004                      (201)       (201)
  Deferred stock-based compensation                                        (116)     (2,113)
  Accumulated other comprehensive income                                    172       3,489
  Retained earnings (accumulated deficit)                                18,845     (10,991)
                                                                      ----------  ----------
      Total stockholders' equity                                        250,056     179,635
                                                                      ----------  ----------

        Total liabilities and stockholders' equity                   $  316,632  $  213,389
                                                                      ==========  ==========`

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,
                                                                                  -------------------------------
                                                                                    2005       2004       2003
                                                                                  ---------  ---------  ---------
Cash flows from operating activities:                                                                            
  Net income                                                                     $  29,836  $  21,717  $  27,323
  Adjustments to reconcile net income to net cash provided by
    operating activities:
      Provision for accounts receivable allowances                                   1,366        737        404
      Provision for excess and obsolete inventories                                    757        158        550
      Depreciation and amortization                                                  4,274      2,817      2,237
      Provision for deferred taxes                                                  14,753     12,821    (18,129)
      Loss on disposal of property and equipment                                       182         93         47
      Stock-based compensation                                                       3,091      3,852      5,966
      Write-off of in-process research and development                                  --         --        636
      Changes in operating assets and liabilities, net of effect of acquisition:
        Accounts receivable                                                        (16,408)   (17,581)   (11,086)
        Inventories                                                                    552     (5,127)    (2,373)
        Prepaid expenses and other current assets                                   (1,270)       343     (1,452)
        Other assets                                                                   939     (1,975)    (1,182)
        Accounts payable                                                             3,898        (40)     3,013
        Accrued liabilities                                                         25,540      9,030      7,031
        Deferred rent and other                                                        366      4,156         --
                                                                                  ---------  ---------  ---------
            Net cash provided by operating activities                               67,876     31,001     12,985
                                                                                  ---------  ---------  ---------

Cash flows from investing activities:                                                       
  Acquisition of property and equipment                                             (8,025)    (9,650)    (3,961)
  Maturities and sales of investments                                               38,600     19,945     30,023
  Purchases of investments                                                        (129,030)   (21,523)   (34,537)
  Payment for acquisition, net of cash                                              (2,448)        --     (4,850)
                                                                                  ---------  ---------  ---------
            Net cash used in investing activities                                 (100,903)   (11,228)   (13,325)
                                                                                  ---------  ---------  ---------

Cash flows from financing activities:                                                       
  Proceeds from issuance of common stock                                             4,697      3,421      1,417
  Proceeds from exercise of stock options                                           17,597      6,361      2,640
  Proceeds from payment of related party note receivable                                --         --      2,510
                                                                                  ---------  ---------  ---------
            Net cash provided by financing activities                               22,294      9,782      6,567
                                                                                  ---------  ---------  ---------
Effect of foreign exchange rate changes on cash                                       (354)       187      1,400
                                                                                  ---------  ---------  ---------
Net increase (decrease) in cash and cash equivalents                               (11,087)    29,742      7,627

Cash and cash equivalents at beginning of year                                      87,236     57,494     49,867
                                                                                  ---------  ---------  ---------
Cash and cash equivalents at end of year                                         $  76,149  $  87,236  $  57,494
                                                                                  =========  =========  =========

Supplementary disclosure of non-cash investing and financing activities:                                         
  Write-off of fully depreciated property and equipment                          $     847  $     187  $      84
                                                                                  =========  =========  =========

Supplemental disclosure of cash flow information:                                                                
  Cash paid during the year for interest                                         $      --  $      --  $      23
                                                                                  =========  =========  =========
  Cash paid during the year for income taxes                                     $   1,696  $     400  $      43
                                                                                  =========  =========  =========`

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

---



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

`Accumulated     Retained
                                                                                            Common Stock    Additional                Deferred         Other        Earnings         Total
                                                                                        ------------------   Paid-In     Treasury   Stock-Based    Comprehensive   (Accumulated  Stockholders'
                                                                                         Shares    Amount    Capital      Stock     Compensation      Income        Deficit)        Equity
                                                                                        --------  --------  ----------  ----------  ------------  ---------------  -----------  ---------------
Balance at January 1, 2003                                                               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
Deferred stock-based compensation, net of cancellations                                      --        --         454          --          (454)              --           --               --
Amortization of deferred stock-based compensation                                            --        --          --          --         4,079               --           --            4,079
Non-employee stock-based compensation                                                        --        --          --          --         1,887               --           --            1,887
                                                                                                                                                                                ---------------
Components of other comprehensive income:
  Changes in unrealized gains (losses) on available-for sale investments, net of taxes       --        --          --          --            --              (40)          --              (40)
  Cumulative translation adjustments                                                         --        --          --          --            --            1,934           --            1,934
  Net income                                                                                 --        --          --          --            --               --       27,323           27,323
                                                                                                                                                                                ---------------
     Total comprehensive income                                                                                                                                                         29,217
                                                                                        --------  --------  ----------  ----------  ------------  ---------------  -----------  ---------------
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
Deferred stock-based compensation, net of cancellations                                      --        --        (470)         --           470                            --               --
Amortization of deferred stock-based compensation                                            --        --          --          --         2,923               --           --            2,923
Non-employee stock-based compensation                                                        --        --          --          --           929               --           --              929
                                                                                                                                                                                ---------------
Components of other comprehensive income:
  Changes in unrealized gains (losses) on available-for sale investments, net of taxes       --        --          --          --            --              (73)          --              (73)
  Cumulative translation adjustments                                                         --        --          --          --            --            1,366           --            1,366
  Net income                                                                                 --        --          --          --            --               --       21,717           21,717
                                                                                                                                                                                ---------------
     Total comprehensive income                                                                                                                                                         23,010
                                                                                        --------  --------  ----------  ----------  ------------  ---------------  -----------  ---------------
Balance at December 31, 2004                                                             41,325        41     189,410        (201)       (2,113)           3,489      (10,991)         179,635
Exercise of stock options                                                                 2,174         2      17,595          --            --               --           --           17,597
Issuance of common stock under employee stock purchase plan                                 314         1       4,696          --            --               --           --            4,697
Tax benefits from exercise of common stock options                                           --        --      18,517          --            --               --           --           18,517
Deferred stock-based compensation, net of cancellations                                      --        --        (165)         --           165                            --               --
Amortization of deferred stock-based compensation                                            --        --          --          --         1,832               --           --            1,832
Non-employee stock-based compensation                                                        --        --       1,259          --            --               --           --            1,259
                                                                                                                                                                                ---------------
Components of other comprehensive income:
  Changes in unrealized gains (losses) on available-for sale investments, net of taxes       --        --          --          --            --              (90)          --              (90)
  Cumulative translation adjustments                                                         --        --          --          --            --           (3,227)          --           (3,227)
  Net income                                                                                 --        --          --          --            --               --       29,836           29,836
                                                                                                                                                                                ---------------
     Total comprehensive income                                                                                                                                                         26,519
                                                                                        --------  --------  ----------  ----------  ------------  ---------------  -----------  ---------------
Balance at December 31, 2005                                                             43,813  $     44  $  231,312  $     (201) $       (116) $           172  $    18,845  $       250,056
                                                                                        ========  ========  ==========  ==========  ============  ===============  ===========  ===============`

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

---





KYPHON INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. ORGANIZATION

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

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Consolidation and Foreign Currency Translation

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

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

Use of Estimates

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

Cash and Cash Equivalents

The Company considers all highly liquid investments purchased with original
maturities of three months or less to be cash equivalents.  Cash and cash
equivalents include money market funds, corporate notes and commercial
paper.  Cash equivalents comprised commercial paper and corporate notes in
the amounts of $7,251,000 and none, for the years ended December 31, 2005 and
2004, respectively.  Cash equivalents are classified as available-for-sale
and therefore are carried at fair market value.  Related unrealized gains and
losses were insignificant for the year ended December 31, 2005.

Investments

Restricted Cash.  Under the terms of its facility lease, as
amended, the Company is required to issue an irrevocable standby letter of
credit to the lessor for the term of the facility lease.  The letter of credit
is secured by a certificate of deposit in the amount of $1,105,000, and
$1,000,000 which was classified as an other asset as of December 31, 2005 and
2004, respectively.

Available-for-Sale.  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.  Realized gains and losses on the sale of all such investments are
reported in earnings and computed using the specific identification cost method
and were insignificant for the years ended December 31, 2005, 2004 and 2003.
All of the Company's investments as of December 31, 2005 have maturities of one
year or less.  The Company's available-for-sale investments are summarized as
follows (in thousands):

`December 31,
                                          ----------------------
                                             2005        2004
                                          ----------  ----------  
Asset-backed securities                  $   29,441  $       --
U.S. government and agency securities         6,506       4,494
Corporate debt secruities                    82,377      19,927
                                          ----------  ----------
  Total short-term investments           $  118,324  $   24,421
                                          ==========  ==========

Asset-backed securities                  $       --         747
Corporate debt securities                        --       3,395
                                          ----------  ----------
  Total long-term investments            $       --  $    4,142
                                          ==========  ==========



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

December 31, 2004                                                                       
U.S. government and agency securities    $    4,507  $       --  $       (13) $   4,494
Corporate debt securities                    19,992          --          (65)    19,927
                                          ----------  ----------  -----------  ---------
  Total short-term investments           $   24,499  $       --  $       (78) $  24,421
                                          ==========  ==========  ===========  =========

Asset-backed securities                  $      747  $       --  $        --  $     747
Corporate debt securities                     3,400          --           (5)     3,395
                                          ----------  ----------  -----------  ---------
  Total long-term investments            $    4,147  $       --  $        (5) $   4,142
                                          ==========  ==========  ===========  =========`

Accounts Receivable Allowances

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

Inventories

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

Depreciation and Amortization

Property and equipment are stated at cost less accumulated depreciation and
amortization.  Depreciation is provided using the straight-line method over the
estimated useful lives of the assets, generally 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 expensed as
incurred.

Asset Retirement Obligations

The fair value of the asset retirement obligation is recognized in the
period in which it is incurred if a reasonable estimate of fair value can be
made.  In addition, the associated asset retirement cost is added to the
carrying amount of the associated asset and this additional carrying amount is
amortized over the life of the asset.  The Company's asset retirement
obligations are associated with its commitment to return property subject to
operating leases in Brussels, Belgium, and Sunnyvale, California to original
condition upon lease termination.  The Company estimated that gross expected
future cash flows of approximately $662,000 would be required to fulfill these
obligations.

As of December 31, 2005, the Company has recorded asset retirement
obligations of approximately $441,000 and a corresponding increase in leasehold
improvements.  This amount represents the present value of expected future cash
flows associated with returning the leased properties to original condition.  A
portion of this amount is subject to foreign exchange rate fluctuations and has
been translated using the exchange rate at December 31, 2005.  The leasehold
improvements are being amortized to depreciation expense over the term of the
lease.  Related amortization expense was approximately $61,000, $39,000 and none
for the years ended December 31, 2005, 2004 and 2003, respectively.

Goodwill and Other Intangible Assets

The Company is amortizing its acquired intangible assets on a straight
line basis over a five to ten year period.  No amortization of goodwill has been
recorded.  Instead, the Company performs an impairment assessment by applying a
fair-value based test on an annual basis, or more frequently if changes in
circumstances or the occurrence of events suggest the remaining value is not
recoverable.  The annual goodwill impairment analysis for the Sanatis GmbH
("Sanatis") acquisition was completed in the first quarter of 2005,
and it was determined that there was no impairment of goodwill at that time.
There have been no events or changes in circumstances subsequent to the
Company's annual test which may indicate the asset is impaired.

Impairment of Long-Lived Assets

Long-lived assets are evaluated for impairment annually and whenever events
or changes in circumstances indicate that the carrying value of an asset may not
be recovered.  An impairment loss would be recognized when estimated
undiscounted future cash flows expected to result from the use of the asset and
its eventual disposition is less than its carrying amount.  Predicting future
cash flows attributable to a particular asset is difficult, and requires the use
of significant judgment.. Impairment, if any, is measured as the amount by which
the carrying amount of a long-lived asset exceeds its fair value.  Through
December 31, 2005, there have been no such impairments.



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 and in some major financial
institutions in 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 and Europe.  The Company performs ongoing
credit evaluations of its customers' financial condition and, generally,
requires no collateral from its customers.

No customer accounted for more than 10% of total net sales for the years
ended December 31, 2005, 2004 and 2003.  No customer accounted for more than 10% of total
accounts receivable at December 31, 2005 and 2004.

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 $1,151,000, $766,000 and $400,000
for the years ended December 31, 2005, 2004 and 2003, respectively.  Costs
incurred related to shipping and handling of products are included in cost of
goods sold.

Research and Development

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

Advertising Costs

Advertising costs, included in sales and marketing expenses, are expensed as
incurred.  Advertising costs were approximately $4,934,000, $3,515,000 and
$3,552,000 for the years ended December 31, 2005, 2004 and 2003, respectively.

Income Taxes

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

Comprehensive Income

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

`December 31,
                                                                    --------------------
                                                                      2005       2004
                                                                    ---------  ---------
Unrealized losses on available-for-sale investments, net of taxes  $    (137) $     (47)
Translation adjustments                                                  309      3,536
                                                                    ---------  ---------
                                                                   $     172  $   3,489
                                                                    =========  =========`



Net Income per Share

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

`Year Ended December 31,
                                                                        -------------------------------
                                                                          2005       2004       2003
                                                                        ---------  ---------  ---------
Net income                                                             $  29,836  $  21,717  $  27,323
                                                                        =========  =========  =========

Weighted-average shares outstanding                                       42,803     40,451     38,461
  Less: weighted-average shares subject to repurchase                         --         (2)       (28)
                                                                        ---------  ---------  ---------
Basic weighted-average shares outstanding                                 42,803     40,449     38,433
                                                                        =========  =========  =========

Dilutive effect of:
  Options to purchase common stock                                         2,533      3,218      3,610
  Warrants                                                                    --          3         47
                                                                        ---------  ---------  ---------
Diluted weighted-average shares outstanding                               45,336     43,670     42,090
                                                                        =========  =========  =========

Net income per share:
  Basic                                                                $    0.70  $    0.54  $    0.71
                                                                        =========  =========  =========
  Diluted                                                              $    0.66  $    0.50  $    0.65
                                                                        =========  =========  =========`

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

`December 31,
                                                                        -------------------------------
                                                                          2005       2004       2003
                                                                        ---------  ---------  ---------

Options to purchase common stock                                             575        509        146
Common stock subject to repurchase                                            --         --         13`

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, 2005 and 2004, 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 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.  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.

The Company uses the intrinsic value method in accounting for its employee
stock options, and presents disclosure of pro forma information  as if the
Company had accounted for stock based compensation using the fair value
method.

The following table, using the effective annual tax rates, provides a
reconciliation of net income and net income per share to pro forma net income
and pro forma net income per share had compensation cost for the Company's stock
option grants to employees been determined based on the fair value of each
option on the date of grant (in thousands, except per share amounts):

`Year Ended December 31,
                                                                        -------------------------------
                                                                          2005       2004       2003
                                                                        ---------  ---------  ---------
Net income, as reported                                                $  29,836  $  21,717  $  27,323
Add:  Stock-based employee compensation expense included in
  reported net income, net of taxes                                        1,136      1,784      2,447
Deduct:  Total stock-based employee compensation expense,
  determined under fair value based method for all awards, net of taxes  (15,698)    (9,897)    (6,291)
                                                                        ---------  ---------  ---------

Pro forma net income                                                   $  15,274  $  13,604  $  23,479
                                                                        =========  =========  =========

Net income per share                                                                                   
Basic:
  As reported                                                          $    0.70  $    0.54  $    0.71
                                                                        =========  =========  =========
  Pro forma                                                            $    0.36  $    0.34  $    0.61
                                                                        =========  =========  =========
Diluted:
  As reported                                                          $    0.66  $    0.50  $    0.65
                                                                        =========  =========  =========
  Pro forma                                                            $    0.34  $    0.31  $    0.56
                                                                        =========  =========  =========`

The weighted-average assumptions used are as follows:

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

                                     Employee Stock Options
                               -------------------------------
                                 2005       2004       2003
                               ---------  ---------  ---------
Risk-free interest rate            3.97%      3.04%      2.58%
Expected volatility                  51%        62%        70%
Expected life (in years)            3.6        4.0        4.0
Dividend yield                       --         --         --


                                 Employee Stock Purchase Plan
                               -------------------------------
                                 2005       2004       2003
                               ---------  ---------  ---------
Risk-free interest rate            3.21%      1.22%      1.15%
Expected volatility                  58%        66%        66%
Expected life (in years)            1.3        1.5        0.7
Dividend yield                       --         --         --`

The weighted-average grant date fair value per share of options granted
during the years ended December 31, 2005, 2004 and 2003 was $12.36, $12.61 and
$8.84, respectively.  The weighted average fair value for shares purchased
through the employee stock purchase plan during the years ended December 31,
2005, 2004 and 2003 were $11.96, $6.80 and $3.96 per share, respectively.

In December 2004, the Financial Accounting Standards Board
("FASB") issued a Statement, "Share-Based Payment, an amendment
of FASB Statements Nos. 123 and 95" ("SFAS No. 123(R)") that
addresses the accounting for share-based payment transactions in which a company
receives employee services in exchange for either equity instruments of the
company or liabilities that are based on the fair value of the company's equity
instruments or that may be settled by the issuance of such equity instruments.
Additional discussion regarding SFAS No. 123(R) is included in "Recent
Accounting Pronouncements" below.

The Company accounts for equity instruments issued to non-employees 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.
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 was 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 using the following weighted-average assumptions:

`Year Ended December 31,
                                   -------------------------------
                                     2005       2004       2003
                                   ---------  ---------  ---------
Risk-free interest rate                3.86%      4.21%      3.92%
Expected volatility                      52%        65%        74%
Expected life (in years)                1.9        4.2        3.2
Dividend yield                           --         --         --`

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

`Year Ended December 31,
                                   -------------------------------
                                     2005       2004       2003
                                   ---------  ---------  ---------
Cost of goods sold                $     124  $     317  $     467
Research and development                949      1,134      2,232
Sales and marketing                   1,416      1,360      2,012
General and administrative              602      1,041      1,255
                                   ---------  ---------  ---------
                                  $   3,091  $   3,852  $   5,966
                                   =========  =========  =========`

Recent Accounting Pronouncements

In November 2004, the FASB issued SFAS No. 151, "Inventory Costs,
an amendment of ARB No. 43, Chapter 4."  SFAS No. 151 amends APB
No. 43, Chapter 4, to clarify those abnormal amounts of idle facility
expense, freight, handling costs, and wasted material (spoilage) should be
recognized as current period charges.  In addition, SFAS No. 151 requires that
allocation of fixed production overhead to the cost of conversion be based on
the normal capacity of the production facilities.  The provisions of SFAS No.
151 are effective for fiscal years beginning after June 15, 2005.  Accordingly,
the provisions of SFAS No. 151 will be effective January 1, 2006 for the
Company.  The adoption of SFAS No. 151 is not expected to have a material impact
on the Company's consolidated financial statements.

In December 2004, the FASB originally issued SFAS No. 123(R).  SFAS No.
123(R) will require companies to measure all stock-based compensation awards
using a fair value-based method and record such expense in their 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), as amended,
is effective for public companies for the first annual period beginning after
June 15, 2005.  Accordingly, the provisions of SFAS No. 123(R) will be effective
January 1, 2006 for the Company.  In March 2005, the SEC issued Staff Accounting
Bulletin ("SAB") No. 107, "TOPIC 14: Share-based payment."
SAB No. 107 addresses the interaction between SFAS No. 123(R) and certain SEC
rules and regulations and provides views regarding the valuation of share-based
payment arrangements for public companies.  SAB No. 107 was effective
immediately.

The Company adopted SFAS No. 123(R) during the first quarter of 2006 using
the modified prospective method. The amounts disclosed within the Company's
footnotes are not necessarily indicative of the amounts that will be expensed
upon the adoption of SFAS No. 123(R).  Compensation expense calculated under
SFAS No. 123(R) may differ from amounts currently disclosed within the Company's
consolidated financial statement footnotes based on changes in the fair value of
the Company's common stock, changes in the number of options granted or the
terms of such options, the treatment of tax benefits and changes in interest
rates or other factors.  The adoption of SFAS No. 123(R) is expected to increase
cost of goods sold and operating expenses by approximately $30,000,000 in the
year ending December 31, 2006 based upon employee stock options outstanding as
of December 31, 2005 and estimated 2006 option grants to employees.  The Company
expects the adoption of SFAS No. 123(R) to have a significant impact on the
consolidated income statements and the presentation of the consolidated
statements of cash flows.

In March 2005, the FASB issued FASB Interpretation No. 47
("FIN No. 47"), "Accounting for Conditional Retirement
Obligations-an interpretation of SFAS No. 143."  FIN No. 47 clarifies
the timing of when a liability should be recognized for legal obligations
associated with the retirement of a tangible long-lived asset.  In addition, FIN
No. 47 clarifies the treatment when there is insufficient information to
reasonably estimate the fair value of an asset retirement obligation.  FIN
No. 47 is effective no later than December 31, 2005.  Retrospective
application for interim financial information is permitted but is not required.
The adoption of FIN No. 47 did not have a material impact on the Company's
consolidated financial statements.

In June 2005, the EITF reached a consensus on Issue No. 05-6
("EITF No. 05-6"), "Determining the Amortization Period for
Leasehold Improvements Purchased after Lease Inception or Acquired in a Business
Combination."  EITF No. 05-6 clarifies that the amortization period for
leasehold improvements acquired in a business combination or placed in service
significantly after and not contemplated at or near the beginning of the lease
term should be amortized over the shorter of the useful life of the assets or a
term that includes the required lease periods and renewals that are reasonably
assured of exercise at the time of the acquisition.  EITF No. 05-6 is to be
applied prospectively to leasehold improvements purchased or acquired in
reporting periods beginning after June 29, 2005.  The adoption of EITF No.
05-6 did not have a material impact on the Company's consolidated financial
statements.

3. BALANCE SHEET COMPONENTS

Inventories (in thousands):

`December 31,
                                                    --------------------
                                                      2005       2004
                                                    ---------  ---------
Raw materials                                      $   4,331  $   5,715
Work-in-process                                        1,656      1,042
Finished goods                                         3,278      4,700
                                                    ---------  ---------
                                                   $   9,265  $  11,457
                                                    =========  =========`

Property and Equipment (in thousands):

`December 31,
                                                    --------------------
                                                      2005       2004
                                                    ---------  ---------
Furniture and fixtures                             $   2,405  $   2,782
Computer software and hardware                         8,194      4,929
Laboratory and manufacturing equipment                 5,327      4,665
Leasehold improvements                                 6,366      5,943
                                                    ---------  ---------
                                                      22,292     18,319
Less:  Accumulated depreciation and amortization      (8,871)    (6,158)
Plus:  Construction-in-progress                        2,556        567
                                                    ---------  ---------
                                                   $  15,977  $  12,728
                                                    =========  =========`

Depreciation and amortization expense relating to the Company's property and
equipment was approximately $4,216,000, $2,931,000 and $2,211,000 for the years
ended December 31, 2005, 2004 and 2003, respectively.

Goodwill and Intangible Assets:

Changes in the carrying amount of goodwill during the years ended
December 31, 2004 and 2005 are as follows (in thousands):

`Goodwill at January 1, 2004           $    4,584
Foreign currency translation                 343
                                       ----------
Goodwill at December 31, 2004              4,927
Foreign currency translation                (617)
                                       ----------
Goodwill at December 31, 2005         $    4,310
                                       ==========`

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

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

                                                     December 31, 2004
                                     --------------------------------------------------
                                       Gross      Foreign
                                      Carrying    Currency    Accumulated                  Amortization
                                       Amount    Translation  Amortization       Net          Period
                                     ----------  ----------   ------------   -----------   ------------
Patent                              $      142  $       35   $        (65)  $       112      5 years
                                     ----------  ----------   ------------   -----------
Total intangibles                   $      142  $       35   $        (65)  $       112
                                     ==========  ==========   ============   ===========`

Amortization expense for the Company's intangible assets was approximately
$35,000, $39,000 and $26,000 for the years ended December 31, 2005, 2004 and
2003, respectively.  Based on the intangible assets held at December 31,
2005, and exchange rates in effect as of the balance sheet date, the Company
expects to recognize amortization expense of approximately $1,131,000 each in
years 2006 and 2007, approximately $1,105,000 in 2008, and approximately
$1,100,000 from 2009 to 2015.

Accrued Liabilities (in thousands):

`December 31,
                                                    --------------------
                                                      2005       2004
                                                    ---------  ---------
Payroll and related expenses                       $  19,665  $  13,052
License acquisition                                   15,000         --
Accrued income taxes                                   6,213      4,616
Legal, accounting and professional fees                2,367      1,620
Clinical studies                                       1,165      1,404
Travel and entertainment                               1,184        466
Professional training courses                            206        666
Other                                                  3,993      2,225
                                                    ---------  ---------
                                                   $  49,793  $  24,049
                                                    =========  =========`

4. LICENSE ACQUISITIONS

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

In November 2005, the Company entered into an agreement with Dr. Harvinder
Sandhu ("Dr. Sandhu"), a well-respected orthopaedic surgeon, to
acquire an exclusive license to Dr. Sandhu's early invention rights concerning a
directional bone tamp for treating vertebral compression fractures.  Under the
terms of the agreement, the Company made an up-front payment of $5,000,000 in
November 2005 and is obligated to make a series of payments totaling up to an
additional $15,000,000.  Based on management judgment, ability and intent, this
amount has been classified as a current liability as of December 31, 2005.  The
$20,000,000 charge was immediately expensed to research and development as the
technology acquired may be used to develop products that have not been approved
for sale by regulatory authorities, have not yet reached technological
feasibility, and was determined to have no alternative future use.  The
license agreement also provides for a capped royalty stream on any future
developed product that practices Dr. Sandhu's technology.

5. ACQUISITIONS

Sanatis GmbH

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 and recorded this amount as additional 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.

InnoSpine, Inc.

On December 30, 2005, the Company entered into a definitive agreement to
acquire all of the outstanding stock of InnoSpine, Inc. ("InnoSpine"),
a privately held company focused on developing and marketing its proprietary
technology platform for the diagnosis and potential treatment of axial low back
pain due to disc degeneration.  The acquisition was made to allow the Company to
expand its focus on spinal deformity correction to include disc repair and
regeneration.  The purchase consideration consisted of an initial purchase price
of $2,500,000 in cash to the shareholders of InnoSpine and other acquisition
costs of $350,000.  In addition, the Company agreed to pay up to an additional
$27,500,000 in cash or stock, based on achievement of clinical and other
milestones as well as royalties on future net sales.

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

The fair value of the net assets acquired from InnoSpine exceeded the
consideration paid by the Company resulting in negative goodwill.  Because the
acquisition involves contingent consideration, the Company is required to
recognize additional purchase consideration equal to the lesser of the negative
goodwill or the maximum amount of contingent consideration of $27,500,000.
Accordingly, contingent consideration totaling $3,516,000 has been included in
the Company's determination of the total purchase price, of which $3,424,000 has
been classified as a non-current liability.  The remaining balance of approximately $92,000 has been classified within accrued liabilities.  The total purchase consideration
was allocated as follows (in thousands):

`Developed technology                  $   11,000
Assumed liabilities                         (267)
Contingent purchase price                 (3,516)
Deferred tax liabilities                  (4,367)
                                       ----------
                                      $    2,850
                                       ==========`

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

Unaudited Pro Forma Financial Information:

The following unaudited pro forma financial information is based on the
respective historical financial statements of the Company, Sanatis and
InnoSpine.  The unaudited pro forma financial information reflects the
consolidated results of operations as if the acquisition of Sanatis and
InnoSpine occurred at the beginning of 2003 and includes the amortization of the
resulting other intangible assets.  The pro forma data includes a non-recurring
charge, consisting of in-process research and development of $636,000 in 2003.
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 2003, and do not purport to
represent what the Company's consolidated results of operations might be for any
future period (in thousands, except per share amounts).

`Year Ended December 31,
                                       ------------------------------------
                                          2005          2004        2003
                                       ----------    ----------  ----------
                                                     (unaudited)

Pro forma net sales                   $  306,082   $   213,414  $  131,028
Pro forma net income                  $   29,653   $    21,552  $   27,286

Pro forma net income per share:                                            

Basic                                 $     0.69   $      0.53  $     0.71
                                       ==========    ==========  ==========
Diluted                               $     0.65   $      0.49  $     0.65
                                       ==========    ==========  ==========

Weighted-average shares outstanding:                                       

Basic                                     42,803        40,449      38,433
                                       ==========    ==========  ==========
Diluted                                   45,336        43,670      42,090
                                       ==========    ==========  ==========`

6. COMMITMENTS AND CONTINGENCIES

Operating leases

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

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

The Company records rent expense on a straight-line basis.  As of December
31, 2005 and 2004, deferred rent of approximately $3,814,000 and $3,923,000,
respectively, had been recorded.  In 2004, the Company received cash incentives
of $3,200,000 from its landlord to be used for leasehold improvements.  These
amounts have been reflected as deferred rent and property and equipment and are
being amortized to rent expense and depreciation expense, respectively, over the
term of the Company's operating lease.  The Company recognized rent expense of
$2,423,000, $2,658,000 and $1,400,000 during 2005, 2004 and 2003,
respectively.

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

`Fiscal year ending December 31,
                                                                      
2006                                                        $   3,178
2007                                                            3,293
2008                                                            2,847
2009                                                            2,804
2010                                                            2,825
Thereafter through 2014                                         9,492
                                                             ---------
Total                                                       $  24,439
                                                             =========`

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, 2005.  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.
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.

Royalty Agreements

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

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 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 the
ITC proceeding 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,  thereby terminating the ITC proceeding in the Company's
favor.  In June 2005, the Delaware District court entered a Consent Judgment
permanently enjoining Disc-O-Tech from further infringing the Company's patent
rights with its SKy Bone Expander device or products not colorably different
from the SKy Bone Expander, which took effect on July 22, 2005.  This Consent
Judgement bars further importation or selling of Disc-O-Tech's SKy Bone Expander device or colorable
variations of that device for performing kyphoplasty in the US market.  This
concluded the litigation in the Company's favor without the possibility of
further trial or appeal.

In November 2005, Dr. Harvinder Sandhu, a well-respected orthopaedic surgeon,
and the Company filed suit in federal district court in Memphis, Tennessee
against Medtronic Sofamor Danek and several other related corporate entities
seeking compensatory and punitive damages and injunctive relief for breach of
contract and related covenants, trade secret theft, fraud, unjust enrichment,
and correction of inventorship of several patents and patent applications
presently owned by Sofamor Danek, including U.S. Patent No. 6,676,665.  The suit
also requests, among other relief, that Sofamor Danek transfer to Dr. Sandhu
ownership of the disputed patents and patent applications.  The dispute concerns
inventions related to an expandable, mechanical bone tamp for use in treating
vertebral compression fractures that Dr. Sandhu invented in the late 1990s and
which he confidentially disclosed and discussed with Sofamor Danek.  The
complaint alleges that Sofamor Danek later filed for several patents
encompassing and claiming Dr. Sandhu's inventions without naming him as inventor
of that technology and that it also incorporated Dr. Sandhu's inventions into
its internal Equestra project without his permission (see Note 4).  The
litigation is in its early stages; no trial date has yet been set.  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.

7. STOCKHOLDERS' EQUITY

Preferred Stock

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

Common Stock

Each share of common stock is entitled to one vote.  The holders of common
stock are also entitled to receive dividends whenever funds are legally
available and when declared by the Board of Directors, subject to the prior
rights of holders of all classes of stock outstanding.  No dividends have been
declared or paid as of December 31, 2005.

Employee Stock Purchase Plan

The Company has an Employee Stock Purchase Plan ("ESPP"), under
which eligible employees are permitted to purchase common stock at a discount
through payroll deductions.  The 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 Company issued approximately
314,000, 338,000 and 176,000 shares of common stock in 2005, 2004, and 2003,
respectively.  At December 31, 2005, approximately 969,000 shares of common
stock remained reserved for future issuance under the ESPP.

Stock Plans

The Company reserved shares of common stock for issuance under the 1996 Stock
Incentive Plan (the "1996 Plan").  Under the 1996 Plan, the Board of
Directors 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.

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

In April 2002, the Board of Directors adopted the 2002 Director Option Plan.
The 2002 Director Option Plan, which will terminate no later than 2012, provides
for the granting of nonqualified stock options to non-employee directors.  At
December 31, 2005, 155,000 shares of common stock remained reserved for future
issuance under the 2002 Director Option Plan.

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

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

`Options Outstanding
                                            ---------------------------------------------
                                                   Employees            Non-Employees
                                            ----------------------  ---------------------
                                                         Weighted               Weighted
                                 Shares                   Average                Average
                                Available    Number of   Exercise   Number of   Exercise
                                for Grant     Shares       Price      Shares      Price
                               -----------  -----------  ---------  ----------  ---------
Balances, January 1, 2003       2,453,538    6,211,881  $    3.79     614,064  $    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     2,665,697    6,382,133       8.14     224,605       2.27
Additional shares reserved      1,971,987           --         --          --         --
Options granted                (3,044,300)   3,044,300      24.29          --         --
Options exercised                      --   (1,441,228)      4.33    (100,316)      1.25
Options cancelled                 475,897     (475,897)     18.43          --         --
                               -----------  -----------  ---------  ----------  ---------

Balances, December 31, 2004     2,069,281    7,509,308      14.77     124,289       3.09
Additional shares reserved      2,123,774           --         --          --         --
Options granted                (2,042,800)   2,042,800      34.03          --         --
Options exercised                      --   (2,115,910)      8.22     (57,972)      3.38
Options cancelled                 424,103     (424,103)     21.72          --         --
                               -----------  -----------  ---------  ----------  ---------

Balances, December 31, 2005     2,574,358    7,012,095  $   21.95      66,317  $    2.84
                               ===========  ===========  =========  ==========  =========`

The options outstanding and exercisable at December 31, 2005 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         2.81  $    0.05     100,000  $    0.05
            $0.13                   2,000         3.22       0.13       2,000       0.13
            $0.31                  25,700         4.10       0.31      25,700       0.31
            $0.77                  50,625         4.23       0.77      50,625       0.77
            $1.00                 445,741         5.23       1.00     445,321       1.00
            $3.00                 133,650         6.17       3.00     123,193       3.00
        $6.95 - $9.50             394,951         7.07       8.64     150,473       8.68
        $9.98 - $15.40          1,180,492         6.98      13.42     772,063      13.30
       $19.40 - $23.86            876,436         8.23      21.63     316,064      21.19
       $23.87 - $34.56          2,635,494         8.65      25.44     654,396      25.24
       $35.32 - $45.34          1,233,323         9.60      38.90      98,744      38.20
                               -----------  -----------  ---------  ----------  ---------
                                7,078,412         8.00  $   21.78   2,738,579  $   14.40
                               ===========  ===========  =========  ==========  =========

Employees                       7,012,095         8.03  $   21.95   2,678,929  $   14.67
Non-employees                      66,317         5.42       2.84      59,650       2.16
                               -----------  -----------  ---------  ----------  ---------
                                7,078,412         8.00  $   21.78   2,738,579  $   14.40
                               ===========  ===========  =========  ==========  =========`

At December 31, 2004, there were 2,802,620 options outstanding granted to
employees and 112,205 options outstanding granted to non-employees which were
exercisable.

8. EMPLOYEE BENEFIT PLAN

The Company maintains a Section 401(k) Plan.  The 401(k) Plan provides
participating employees with an opportunity to accumulate funds for retirement
and hardship.  Eligible participants may contribute up to 100% of their eligible
earnings to the Plan Trust.  The Company started matching employees'
contributions to the plan on March 15, 2003 at 25% of employee's individual
401(k) contributions up to a maximum matching contribution of $2,000 per
calendar year.  Beginning in January 2005, the Company match was adjusted to 50%
of an employee's individual 401(K) contributions up to a maximum matching
contribution of $2,000 per calendar year.  Beginning in January 2006,
the Company match was changed to 50% of the first 5% of
compensation deferred to the 401(k) plan.  In addition, if
any employee receives less than a $2,000 match under the new formula,
the Company will true-up the 401(k) matching contribution at year-end to
50% of an employee's 401(k) contributions up to a $2,000 matching
contribution per calendar year. The Company's matching
contributions totaled $1,084,000, $620,000 and $372,000 in 2005, 2004 and 2003,
respectively.

9. 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
years ended December 31, 2005, 2004 and 2003 were $207,000, $216,000 and
$216,000, respectively.

10. 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,
                                                    -------------------------------
                                                      2005       2004       2003
                                                    ---------  ---------  ---------
U.S.                                               $  49,414  $  35,153  $  14,636
International                                         (1,298)       464     (1,313)
                                                    ---------  ---------  ---------
Total income before income taxes                   $  48,116  $  35,617  $  13,323
                                                    =========  =========  =========

Current
  Federal                                          $  15,576  $   7,892  $   4,152
  State                                                4,399      1,285        907
  Foreign                                                595        216        500
                                                    ---------  ---------  ---------
    Total current                                     20,570      9,393      5,559
                                                    ---------  ---------  ---------

Deferred
  Federal                                               (731)     4,286    (15,803)
  State                                               (1,569)       433     (3,336)
  Foreign                                                 10       (212)      (420)
                                                    ---------  ---------  ---------
    Total deferred                                    (2,290)     4,507    (19,559)
                                                    ---------  ---------  ---------

Total provision (benefit) for income taxes         $  18,280  $  13,900  $ (14,000)
                                                    =========  =========  =========`

At December 31, 2005, the Company had approximately $500,000 and $4,800,000
in federal and state net operating loss carryforwards, respectively, to reduce
future taxable income.  The federal and state carryforwards have expiration
dates beginning in 2023 and 2010, respectively, if not utilized.

At December 31, 2005, the Company had research and development tax credit
carryforwards of approximately $2,236,000 and $3,564,000 for federal and state
income tax purposes, respectively.  If not utilized, the federal research and
development tax credit carryforwards will expire beginning in 2018.  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 for the Company, as defined, occurred
on August 8, 1996, December 14, 1999 and May 17, 2002.  In addition, the Company
entered into a definitive agreement to acquire InnoSpine in December 2005.
Ownership changes for InnoSpine, as defined, occurred on March 16, 2004 and
December 30, 2005.  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 give rise to the Company's
deferred tax assets and liabilities are as follows (in thousands):

`December 31,
                                                         --------------------
                                                           2005       2004
                                                         ---------  ---------
Net operating loss carryforwards                        $     441  $   5,507
Research and development credit carryforwards               4,675      3,638
Capitalized research and development costs                    397        479
Purchased research and development                         11,122      3,451
Other, accruals and reserves                                4,910      4,471
                                                         ---------  ---------
Total deferred income tax assets                           21,545     17,546
                                                         ---------  ---------

Intangibles                                                (4,367)        --
                                                         ---------  ---------
Total deferred income tax liabilities                      (4,367)        --
                                                         ---------  ---------

   Net deferred income tax liabilities                  $  17,178  $  17,546
                                                         =========  =========`

Management periodically evaluates the recoverability of the deferred tax
assets and recognizes the tax benefit only as reassessment demonstrates that
they are more likely than not realizable.  At December 31, 2005, and 2004, 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,
                                                    -------------------------------
                                                      2005       2004       2003
                                                    ---------  ---------  ---------
Federal statutory rate                                  35.0 %     35.0 %     34.0 %
State, net of federal benefit                            4.7        4.7        5.8
Deferred stock-based compensation                         --         --      (35.7)
Tax reserves                                             0.4       (0.2)      30.6
Other permanent difference                               1.4        4.0        1.6
Change in valuation allowance                             --         --     (142.0)
Research and development tax credits                    (3.5)      (4.5)        --
                                                    ---------  ---------  ---------
Total provision (benefit) for income taxes              38.0 %     39.0 %   (105.7)%
                                                    =========  =========  =========`

11. OPERATING SEGMENT AND GEOGRAPHIC INFORMATION

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

`Net Sales                 Long-Lived Assets
                    ----------------------------    -------------------------
                       Year Ended December 31,            December 31,
                    ----------------------------    -------------------------
                      2005      2004      2003       2005     2004     2003
                    --------  --------  --------    -------  -------  -------
United States            84 %      88 %      90 %       78 %     83 %     86 %
Germany                   9         6         3          1        1        1
Other                     7         6         7         21       16       13
                    --------  --------  --------    -------  -------  -------
                        100 %     100 %     100 %      100 %    100 %    100 %
                    ========  ========  ========    =======  =======  =======`

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

12. QUARTERLY FINANCIAL DATA (UNAUDITED)

The following tables contain selected unaudited Consolidated Income Statement
data for each quarter of 2005 and 2004 (in thousands, except per share
amounts):

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




                                                             Year 2004 Quarter Ended
                                                ----------------------------------------------
                                                Mar. 31,     Jun. 30,     Sep. 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


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

KYPHON INC. 
SCHEDULE II
VALUATION AND QUALIFYING ACCOUNTS
FOR THE YEARS ENDED DECEMBER 31, 2003, 2004 AND 2005
(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 2003                        $        100          404             4  $       500
  Fiscal year ended 2004                                 500          737           183        1,054
  Fiscal year ended 2005                        $      1,054        1,366           843  $     1,577

Allowance for inventories valuation:
  Fiscal year ended 2003                        $        607          550           532  $       625
  Fiscal year ended 2004                                 625          158           254          529
  Fiscal year ended 2005                        $        529          757           295  $       991

Valuation allowance for deferred tax assets:
  Fiscal year ended 2003                        $     20,398           --        20,398  $        --
  Fiscal year ended 2004                                  --           --            --           --
  Fiscal year ended 2005                        $         --           --            --  $        --`





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

None.

ITEM 9A.  CONTROLS AND PROCEDURES

Disclosure Controls and Procedures

Evaluation of disclosure controls and
procedures.    The Chief Executive Officer, Richard W.
Mott, and Chief Operating Officer, Arthur T. Taylor, evaluated the effectiveness
of Kyphon's disclosure controls and procedures as of the end of the period
covered by this report, and concluded that Kyphon's disclosure controls and
procedures were effective to ensure that information Kyphon is required to
disclose in the reports that it files or submits with the Securities and
Exchange Commission under the Securities Exchange Act of 1934 is recorded,
processed, summarized and reported, within the time periods specified in the
Commission's rules and forms, and to ensure that information required to be
disclosed by Kyphon in the reports that it files or submits under the Exchange
Act is accumulated and communicated to Kyphon's management, including its
principal executive officer and principal financial officer, as appropriate to
allow timely decisions regarding required disclosure.

Internal Control Over Financial Reporting

Management's annual report on internal control over financial
reporting.    Management's report on Kyhon's internal
control over financial reporting is included on page 51 of Item 8 of this Annual
Report on Form 10-K, and the attestation report of our independent registered
public accounting firm on page 53 of Item 8 of the this Annual Report on Form
10-K is incorporated by reference to Item 8 of this Annual Report on Form 10-
K.

Changes in internal control over financial
reporting.    During the quarter ended December 31,
2005, there were no changes in Kyphon's internal control over financial
reporting (as defined in Rule 13a-15(f) under the Exchange Act) that have
materially affected, or are reasonably likely to materially affect, Kyphon's
internal control over financial reporting.

ITEM 9B.  OTHER INFORMATION

None.



PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE
REGISTRANT

The information required by this Item is incorporated by reference to the
definitive proxy statement for our 2006 Annual Meeting of Stockholders to be
filed with the Securities and Exchange Commission within 120 days after the end
of our 2005 fiscal year (the "2006 Proxy Statement").

ITEM 11. EXECUTIVE COMPENSATION



The information required by this Item is incorporated by reference to the
2006 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
2006 Proxy Statement.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

The information required by this Item is incorporated by reference to the
2006 Proxy Statement.

ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES



The information required by this Item is incorporated by reference to the
2006 Proxy Statement.

ITEM 15.  EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

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

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

(3) Exhibits



|Number    |  | Description                                                                                                                                                                    
|--------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|          |  |                                                                                                                                                                                
|3.2       |  | Amended and Restated Certificate of Incorporation of the
registrant.                                                                                                           
|          |  |                                                                                                                                                                                
|3.4       |  | Amended and Restated 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.                                                                      
|10.18*(6) |  | First Amendment to lease Agreement, made as of September 28, 2005, by and
between Moffett Office Park Investors LLC, a Delaware limited liability company, and Kyphon Inc.     
|21.1      |  | Subsidiaries of the registrant.                                                                                                                                                
|23.1      |  | Consent of PricewaterhouseCoopers LLP,
Independent Registered Public Accounting Firm                                                                                           
|31.1      |  | Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                            
|31.2      |  | Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                            
|32.1      |  | Certifications of Chief Executive Officer and Chief Financial
Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.



(1)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 as filed with the Securities Exchange Commission on November 13, 2002.

(3)Incorporated by reference from
our Current Report on Form 8-K as filed with the Securities Exchange Commission on March 7, 2003.

(4)Incorporated by reference from
our Quarterly Report on Form 10-Q as filed with the Securities Exchange Commission on November 14, 2003.

(5)Incorporated by reference from
our Current Report on Form 8-K as filed with the Securities Exchange Commission on February 1, 2005.

(6)Incorporated by reference from
our Quarterly Report on Form 10-Q as filed with the Securities Exchange Commission on November 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, 2006.

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



|Signature                                             |  | Title                                                                                |  | Date         
|----------------------------------------------------- |  | ------------------------------------------------------------------------------------ |  | -------------
|/s/ RICHARD W.
MOTT
Richard W. Mott                   |  | President, Chief Executive Officer and Director (Principal
Executive Officer)        |  | March 2, 2006
|                                                      |  |                                                                                      |  |              
|/s/ Arthur T. Taylor
ARTHUR T. TAYLOR                 |  | Vice President, Chief Operating Officer (Principal Accounting and Financial Officer) |  | March 2, 2006
|                                                      |  |                                                                                      |  |              
|/s/ JAMES T.
TREACE
James T. Treace                   |  | Chairman of the Board                                                                |  | March 2, 2006
|                                                      |  |                                                                                      |  |              
|/s/ STEPHEN M. CAMPE                                  |  | Director                                                                             |  | March 2, 2006
|Stephen M. Campe                                      |  |                                                                                      |  |              
|                                                      |  |                                                                                      |  |              
|/s/ DOUGLAS W.
KOHRS
Douglas W. Kohrs                 |  | Director                                                                             |  | March 2, 2006
|                                                      |  |                                                                                      |  |              
|/s/ JACK W. LASERSOHN
Jack W. Lasersohn               |  | Director                                                                             |  | March 2, 2006
|                                                      |  |                                                                                      |  |              
|/s/ LOUIS J. LAVIGNE. JR.
Louis J. Lavigne, Jr.       |  | Director                                                                             |  | March 2, 2006
|                                                      |  |                                                                                      |  |              
|/s/ KAREN D. TALMADGE,
PH.D.
Karen D. Talmadge, Ph.D. |  | Executive Vice President, Co-Founder, Chief Science Officer and Director             |  | March 2, 2006
|                                                      |  |                                                                                      |  |              
|/s/ ELIZABETH H. WEATHERMAN
Elizabeth H. Weatherman   |  | Director                                                                             |  | March 2, 2006



---