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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549



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FORM 10-K



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(Mark One)

|x | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ------------------------------------------------------------------------------------



For the fiscal year ended December 31, 2003



or



| ̈ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ----------------------------------------------------------------------------------------



Commission File Number 000-49804



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Kyphon Inc.

(Exact name of Registrant as specified in its charter)



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|                         |  |                                     
|------------------------ |  | ------------------------------------
|Delaware                 |  | 77-0366069                          
|(State of incorporation) |  | (I.R.S. Employer Identification No.)



1350 Bordeaux Drive

Sunnyvale, California, 94089

(Address of principal executive offices, including Zip Code)



(408) 548-6500

(Registrants telephone number, including area code)



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



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



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

Common
Stock,            $0.001 par value

(Title of Class)



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



Indicate by check mark 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 the 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 Registrant is an accelerated filer (as defined in Rule
12b-2 of the Act).    YES  x    NO ̈



The aggregate market value of the voting stock held by non-affiliates of the registrant,
based upon the closing sale price of the Common Stock on June 30, 2003 (which is the last business day of registrants most recently completed second fiscal quarter), as reported on the Nasdaq National Market was approximately $221.9 million.
Shares of Common Stock held by each executive officer and director and by each person who owns 5% or more of the outstanding Common Stock have been excluded in that such persons may be deemed affiliates. This determination of affiliate status is not
necessarily a conclusive determination for other purposes.



At March 1, 2004,
the Registrant had 39,940,141 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.



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KYPHON INC.

FISCAL YEAR 2003 FORM 10K ANNUAL REPORT

TABLE OF CONTENTS



|           |  |                                                                                       |  |     
|---------- |  | ------------------------------------------------------------------------------------- |  | ----
|           |  |                                                                                       |  | Page
|PART I     |  |                                                                                      
|Item 1     |  | Business                                                                              |  | 3   
|Item 2     |  | Properties                                                                            |  | 19  
|Item 3     |  | Legal Proceedings                                                                     |  | 19  
|Item 4     |  | Submission of Matters to a Vote of Security Holders                                   |  | 19  
|           | 
|PART II    |  |                                                                                      
|Item 5     |  | Market for the Registrants Common Equity and Related Stockholder Matters             |  | 19  
|Item 6     |  | Selected Consolidated Financial Data                                                  |  | 20  
|Item 7     |  | Managements Discussion and Analysis of Financial Condition and Results of Operations |  | 22  
|Item 7A    |  | Quantitative and Qualitative Disclosures about Market Risk                            |  | 39  
|Item 8     |  | Consolidated Financial Statements and Supplementary Data                              |  | 41  
|Item 9     |  | Changes in and Disagreements with Accountants on Accounting and Financial Disclosure  |  | 69  
|Item 9A    |  | Controls and Procedures                                                               |  | 69  
|           | 
|PART III   |  |                                                                                      
|Item 10    |  | Directors and Executive Officers of the Registrant                                    |  | 69  
|Item 11    |  | Executive Compensation                                                                |  | 69  
|Item 12    |  | Security Ownership of Certain Beneficial Owners and Management                        |  | 69  
|Item 13    |  | Certain Relationships and Related Transactions                                        |  | 69  
|Item 14    |  | Principal Accountant Fees and Services                                                |  | 69  
|           | 
|PART IV    |  |                                                                                      
|Item 15    |  | Exhibits, Financial Statement Schedules and Reports on Form 8-K                       |  | 70  
|           | 
|Signatures |  | 72                                                                                   



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PART 1



This Annual Report on Form 10-K
contains forward-looking statements within the meaning of the federal securities laws. These statements include those concerning the following: our intentions, beliefs and expectations regarding our future success and results; 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 operating results; our expectations regarding our revenues and customers; and our
distributors and territorial expansion efforts. These statements are subject to risks and uncertainties that could cause actual results and events to differ materially. For a detailed discussion of these risks and uncertainties, see the
Managements Discussion and Analysis of Financial Condition and Results of Operations section of this Form 10-K.



Kyphon undertakes no obligation to update forward-looking statements to reflect events or circumstances occurring after the date of this Form 10-K.



|ITEM 1. |  | BUSINESS
|------- |  | --------



Overview



We develop medical devices to
restore spinal anatomy using minimally invasive technology. Our devices are used primarily by surgeons who repair compression fractures of the spine caused by osteoporosis and cancer. Our commercial products, comprising our KyphX instruments,
utilize our proprietary balloon technology. Surgeons use these instruments to help repair compression fractures during minimally invasive spine surgeries. Most alternative spine fracture treatments are either highly invasive or are pain management
therapies.



We believe there are approximately 700,000 clinically-diagnosed
spine fractures each year due to osteoporosis in the United States and Europe in approximately 550,000 patients. Osteoporosis, a disease that primarily affects women over the age of 50, is characterized by bone deterioration, leading to an increased
susceptibility to spine fractures. These fractures can result in an increased risk of death, significant pain, reduced physical function, decreased respiratory function and diminished quality of life. We also estimate that each year in the United
States and Europe 150,000 fractures occur in 50,000 patients due to cancer, with similar debilitating consequences to osteoporotic fractures. The primary cancer types that contribute to spinal fracture are multiple myeloma and spinal bone
metastases. Additionally, we estimate there are 100,000 patients per year in the United States and Europe that suffer traumatic vertebral compression fractures that may be treatable by minimally invasive techniques similar to treatments today for
fractures caused by osteoporosis and cancer.



As of December 31, 2003, we had
trained more than 3,900 physicians in the United States, Europe and Asia Pacific in the use of our KyphX instruments, and these physicians had used our instruments in over 60,000 spine surgeries. To support these physicians, we have built a
large and growing worldwide direct sales organization that numbered in excess of 200 professionals as of December 31, 2003. Based on our experience to date and supported by published peer-reviewed medical journal articles, we believe that use of our
KyphX instruments during minimally invasive spine surgery leads to significant patient benefits, including the ability to reverse the collapse of the bone caused by the spine fracture. Reversal of collapsed bone in the spine can reduce spine
deformity, thereby increasing mobility and improving respiratory function in patients. 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, these procedures using our instruments may result in serious complications, including embolization, nerve injury, paralysis and death.



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. As of December 31, 2003, we had 27 U.S. issued patents, 26 issued
foreign patents, 40 pending U.S. patent applications, 140 pending foreign applications and 25 patents that we exclusively licensed from Bonutti Research in August 2002, which primarily cover the use of inflatable devices in and around soft tissue in
the spine.



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In February 2003, we acquired Sanatis GmbH, Sanatis, a privately-held developer and manufacturer of
orthopedic biomaterials based in Rosbach, Germany. This acquisition, which provides us with a core competency in biomaterials, 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 KyphOs calcium phosphate cement, in December 2003, and we are now authorized to sell this
material in Europe.



We intend to pursue the development and commercialization
of spine products arising from this acquisition and from our acquisition of the Bonutti patents to complement our existing KyphX instruments and to leverage our spine sales force. The full commercialization of products from these acquisitions
will require research, development, and regulatory approvals and/or clearances, and may require clinical studies prior to market launch. In addition, we may pursue additional acquisitions, including acquisitions of non-spine fracture treatment
technologies or biologics, as 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 Spine 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 body compression fractures. Fractures of the vertebral body, located at the front of the spinal column, can cause the spine to tilt forward. Over time,
these fractures can result in a curved deformity of the spine and a forward-stooped posture called kyphosis. Vertebral compression fractures are caused primarily by deterioration of the inner cancellous bone due to osteoporosis. Other causes of
spine fractures include trauma, cancerous tumors and infection.



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



| |  | Increased Risk of Mortality. In a 2000 study of 6,459 women with osteoporosis followed for 3.8 years, those women who sustained a spine fracture during the study were 8.7
times more likely to die during the time period of the study than those women who did not experience a fracture.
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Acute and Chronic Pain. About one-third of the spine fractures caused by osteoporosis are accompanied by severe acute back pain. In addition, the spine deformity caused by
these fractures can change the position of muscles and ligaments, leading to chronic pain. In a 1998 study of 7,223 women over the age of 65, those who had a single unrepaired spine fracture that had set in its collapsed position were two times more
likely to suffer back pain than equivalently-aged women without spine deformity. Acute back pain is common to fractures caused by cancer and trauma as well.
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Health Effects Resulting from Organ Compression. Fractured and collapsed vertebrae shorten and curve the spine, moving the ribs down toward the pelvis and compressing the
chest and stomach. Compression of the lungs can create new, or worsen already existing, respiratory disorders, including lung disease and pneumonia. A German and a Canadian study published in the 1990s, involving a total of 108 participants,
demonstrated that patients with spine fractures showed a statistically significant decrease in lung capacity that correlated with spine deformity. In addition, kyphosis can lead to compression of the stomach and a resultant reduced appetite and
weight loss.
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| |  | Functional Limitation. Spine fractures can cause prolonged or permanent disability, reducing mobility and impairing other physical functions. Patients with spine fractures
can require significant assistance, including the use of walkers or other aids, during normal physical activities. In a 2001 study of 1,395 post-menopausal women, patients with one or more unrepaired spine fractures scored significantly lower on a
standardized test for physical function than those who had no fractures. The loss in quality of life increased with additional fractures. Multiple fractures are common in patients from cancers such as multiple myeloma.
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Increased Risk of Additional Fractures. The change in alignment of the spine can shift a patients center of balance, increasing the risk of falls and additional
fractures, particularly of the spine and hip. In a 1991 study of 1,098 post-menopausal women followed for 4.7 years, the presence of one spine fracture increased the risk of subsequent spine fractures by five times compared to the risk of someone
suffering a first fracture. The presence of two or more spine fractures increased the risk of additional spine fractures by 12 times in the same timeframe. In addition, a 2001 study prospectively following 6,788 women over the age of 50 for the
incidence of osteoporotic fractures found that one or more spine fractures increased the risk of hip fracture by 4.5 times, while the presence of two or more spine fractures increased the risk of hip fracture by 7.2 times.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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



Market Opportunity for the Treatment of Spine Fractures



We
believe that each year in the United States and Europe an estimated 700,000 clinically diagnosed spine fractures occur due to osteoporosis as well as 150,000 fractures occurring in 50,000 patients due to cancer, and 100,000 fractures caused by
trauma. In the U.S. alone, we believe there are an additional 440,000 osteoporotic fractures that go undiagnosed and untreated. 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 are hospitalized due to pain associated with spine fractures caused by osteoporosis, resulting in annual costs estimated to be in excess of
$1.6 billion. The number of fractures caused by osteoporosis is increasing more rapidly than the aging of the population, which has been assumed to be related to our increasingly sedentary lifestyles.



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. 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.



Alternative
Means for the Treatment of Spine Fractures



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



Conventional Spine Surgery



Spine surgery is complex and risky given the proximity of the surgical site to the spinal
cord and major organs. Conventional spine surgery can repair fractured vertebrae and restore height, but is highly invasive and involves significant risks. These surgeries involve making long incisions in the patients chest or back



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so that stainless steel instruments can move the fractured bones back into their normal position. However, the
instruments used in these surgeries are not optimally designed to manipulate deteriorated osteoporotic bone. The fractured bones are then held in place by metal implants, which, in the case of elderly patients with osteoporosis, can fail to hold due
to the softness of the inner cancellous bone to which they are attached. As a result, this surgery is performed in very limited circumstances to treat osteoporosis-related vertebral compression fractures. The invasiveness of conventional spine
surgery may lead to death, spinal cord injury, extensive post-operative hospital stays and prolonged bed rest for recovery. Additional complications may include bowel, lung and nerve damage, pain, embolization, infection and blood clots. Due to
these risks among others, conventional spine surgery is rarely performed to treat cancer-related fractures, and is used to treat only a portion of the trauma-related fractures.



Pain Management Therapies



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



| |  | bed rest, in the hospital or at home;
| | - | -------------------------------------



| |  | prescription and over-the-counter pain medication;
| | - | --------------------------------------------------



| |  | back braces;
| | - | ------------



| |  | home health care;
| | - | -----------------



| |  | physical therapy;
| | - | -----------------



| |  | exercise; and
| | - | -------------



| |  | chiropractic care.
| | - | ------------------



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.
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 unrepaired spine fractures.



In vertebroplasty, a physician, typically an interventional radiologist, places one or two
large needles into the fractured vertebra, and injects bone filler material into the collapsed vertebral body. The bone filler most commonly used in vertebroplasty is bone cement. The FDA has not approved a cleared bone cement or any other bone void
filler for use in the spine. 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.



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Our Products



Kyphon provides surgeons with tools to help repair fractures during minimally invasive spine surgery. Our instruments have also been used in open surgical procedures. We
generally refer to our products as the KyphX instruments.



Minimally
invasive spine fracture surgeries using our KyphX instruments typically involve the insertion of two of our disposable proprietary balloon devices into the fractured bone, although only one balloon may be used occasionally. The surgeon
inflates our balloons to compact and move the deteriorated bone. As a result of the inflation of the balloons, some 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 developed products that facilitate treatment of chronic fractures that may have partially healed. If the patient suffered a prior partial collapse of the vertebral body that healed in its deformed position,
and then that same vertebral body fractures again, leading to further collapse, the balloon is only likely to address the change in anatomy related to the second fracture. 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, which can include bone cement, a plastic polymer that hardens in place. We believe that surgeons typically use a relatively thick bone
cement at low pressure and under manual control. Although bone cement may be used by surgeons if they feel it is in the best interest of the patient, we may not promote bone cement for use in the spine without first receiving additional regulatory
approval or clearance. Currently, there is no bone filler that has been approved or cleared by the FDA. While our KyphXHV-R Bone Cement is CE Marked for a specific minimally invasive spine procedure known as kyphoplasty in
Europe, it is not yet approved or cleared for use in the United States.



We
have trained more than 3,900 physicians, including 900 in Europe and 80 in other international sites, primarily Asia Pacific, in the use of our KyphX instruments. We believe these physicians have used our instruments in over 60,000 surgeries
involving spine fractures.



Based upon published reports of clinical results,
discussions with surgeons who have used our instruments, and our own research, we believe that the use of our KyphX instruments during minimally invasive spine surgery may lead to significant clinical outcomes, including one or more of the
following:



| |  | restoration of collapsed vertebrae;
| | - | -----------------------------------



| |  | reduction of spinal deformities;
| | - | --------------------------------



| |  | reduction of pain; and
| | - | ----------------------



| |  | enhanced quality of life.
| | - | -------------------------



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, hand, tibia (a leg bone), radius (an arm bone) and calcaneus (the heel bone). Before we can promote and market in the United States the use of our KyphX instruments in
any specific procedure, or claim any treatment benefits from any procedure with our products such as pain reduction, enhanced quality of life, or reduction of spinal deformities, we will need to receive additional FDA clearance or approval and we
may need to conduct clinical studies to document the benefits, if any.



We have
recently submitted to the FDA a 510(k) application for our proprietary bone cement KyphX HV-R. This regulatory submission is in response to the FDAs recent clarification regarding the classification of bone cement for the treatment of
pathological fractures. We are also currently discussing with the FDA the necessary clinical data to support clearance of the use of our bone cement in a kyphoplasty procedure. We cannot assure you that our data, if available or subsequently
completed, will support FDA clearance. If we fail to obtain additional FDA approvals that will allow us to promote the treatment benefits of the KyphX Inflatable Bone Tamps, our ability to expand the commercialization of our products may be
impaired.



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The Use of KyphX Instruments during Minimally Invasive Spine Surgery



Spine fracture surgeries using our KyphX instruments are minimally invasive and are
generally performed by spine-focused orthopedic surgeons and neurosurgeons. 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. 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 material leaks.



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 an outpatient setting. Surgeons choose local or general anesthesia based on patient 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.



Business 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 Surgery Using Our KyphX Instruments as the Standard of Care for Spine Fracture Repair. We intend to support clinical efforts to establish that
treating spine fractures with a specific minimally invasive surgical procedure using our KyphX instruments provides significantly improved patient outcomes versus the pain management therapies typically prescribed by physicians today.
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Continue to Penetrate the Spine Market with Our Established Direct Sales Force. Our instruments are sold in the United States directly to hospitals by our experienced sales
team. By leveraging their extensive medical device experience, our sales people are able to identify key physicians within these hospitals and provide effective customer assistance to continue the market adoption of our instruments. In Europe, our
products are sold by direct sales forces in the major countries as well, sometimes complimented with agents or sub-distributors.
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Educate Referring Physicians. Patients with spine fractures often are not referred to spine surgeons for treatment, but instead are prescribed pain management therapies by
primary care physicians. Our objective is to educate primary care physicians and other medical advisers on the use of our KyphX instruments as an alternative to conventional spine fracture treatment and conservative pain management therapies.
During 2003, we initiated a pilot program whereby selected sales representatives call on primary care physicians to educate them about our instruments. As of December 31, 2003, we had expanded this group to approximately 40 individuals in the United
States and Europe.
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Expand Marketing Claims. The FDA does not allow us to discuss or mention bone cement in our marketing and promotional claims in the United States, although we are permitted
to mention bone cement in Europe, and we sell a bone cement in that market. Bone cement is the filler material
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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commonly used in the spine by surgeons when they perform spine fracture repair. We have initiated
discussions with the FDA regarding the necessary clinical and preclinical data to allow us to support FDA clearance for the promotion of bone cement as a bone filler material in conjunction with a kyphoplasty procedure and to determine the benefits
resulting from that procedure. In Europe, we have initiated a post-marketing clinical study comparing kyphoplasty to conventional treatments of bed rest, pain medication and bracing. We believe the results of this and other studies, if successful,
may allow us to expand our marketing and third-party reimbursement efforts.



| |  | Support Appropriate Levels of Physician Reimbursement in the United States. In all 50 states and in the District of Columbia, Medicare reimburses physicians at varying
payment levels for their services when they perform procedures using our KyphX instruments. We intend to use peer-reviewed physician journal articles, data from our European trials and support from leading physicians who are familiar with the
KyphX instruments to continue to support further appropriate levels of physician reimbursement.
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Continue Revenue Growth Through New Product Acquisition and Development. Our minimally invasive spine sales force is an important asset with the capacity to sell new products
that complement our KyphX Instruments including KyphX product line extensions as well as new technologies that we develop or acquire from others. In August 2002, we acquired the rights to a series of patents, now numbering 25, owned by
Bonutti Research and covering the use of inflatable devices in and around soft tissue in the spine. In February 2003, we acquired Sanatis, a privately-held developer and manufacturer of orthopedic biomaterials based in Rosbach, Germany. We intend to
pursue the development and commercialization of spine products arising from these acquisitions to complement our existing KyphX instruments and leverage our spine sales force. The commercialization of products from these acquisitions as well
as our own internal efforts will require research, development, and regulatory approvals and/or clearances, and may require clinical studies prior to market launch. We intend to pursue other external business development opportunities as well to
help us achieve our goals, which may include opportunities outside the spine.
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Products



We currently sell the
following instruments for use in spine fracture procedures:



|                     |  |                                                                     |  |                                                 
|-------------------- |  | ------------------------------------------------------------------- |  | ------------------------------------------------
|Product Category     |  | Description                                                         |  | Function                                        
|Bone Access Systems  |  | Set of small disposable tools                                       |  | Create working channel into fractured bone      
|                     |  |                                                                    
|Inflatable Bone Tamp |  | Disposable balloon catheter                                         |  | Compact soft inner bone and move hard outer bone
|                     |  |                                                                    
|Inflation Syringe    |  | Disposable syringe with rotating handle and pressure gauge          |  | Inflate the KyphX Xpander Inflatable Bone Tamp  
|                     |  |                                                                    
|Bone Filler Device   |  | Disposable stainless steel nozzle with inner rod and plastic handle |  | Deliver bone filler material into bone cavity   
|                     |  |                                                                    
|Bone Biopsy Device   |  | Disposable stainless steel tube and rod                             |  | Take sample of bone for evaluation purposes     
|                     |  |                                                                    
|Curette              |  | Disposable stainless steel device with articulating tip             |  | Scrape or score bone in the spine               



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Bone Access Systems. Bone Access Systems are sterile sets of small disposable surgical tools used to access
and create a working channel into the fractured bone. 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 tools. 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.



Inflatable Bone Tamps. Our proprietary KyphX Xpander 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 cannot do this without a large incision and without significant tissue and bone disruption. Unlike other bone tamps, the KyphX Xpander Inflatable Bone Tamp
contains 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 Xpander Inflatable Bone Tamp is carefully inflated
under X-ray monitoring. This inflation applies direct mechanical force to compact the soft inner bone and move the broken hard outer bone back towards its prefracture position. Products introduced during 2003 include the KyphX Elevate
Inflatable Bone Tamp, the KyphX Exact Inflatable Bone Tamp, and the KyphX Express Inflatable Bone Tamp, variations of the basic KyphX Xpander.



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



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



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.



Curette.Our KyphXCurette is a disposable, stainless steel device with an articulating tip that is used to scrape or score bone in the spine.



Bone Fillers. We have developed our own KyphX HV-R® polymethylmethacrylate (PMMA) bone cement with the
appropriate handling characteristics for minimally invasive use in the spine. We obtained a CE Mark for KyphX HV-R bone cement in October 2002 and began selling it in Europe to spine surgeons who use our devices. We completed testing
to support U.S. regulatory submissions for marketing approval. In December 2003 we submitted a 510(k) for clearance of our bone cement as a bone filler material to be used in conjunction with a kyphoplasty procedure.



In Europe, we are conducting a kyphoplasty clinical study of our devices using KyphXHV-R. The primary purpose for conducting the European study is to gather local clinical data to support our sales and marketing efforts, as well as to support reimbursement of our KyphX instruments in various European countries. We
expect to continue patient enrollment throughout 2004, and we will continue to monitor these patients with the goal of using local data to support our European marketing and reimbursement efforts.



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We obtained a CE Mark for our first product from the acquisition of Sanatis, our KyphOs calcium phosphate cement, in December 2003, and we are
now authorized to sell this material in Europe.



Sales and Marketing



We market and sell our KyphX instruments through a direct sales
force in the United States. Our target customer base includes the approximately 5,500 physicians who perform spine surgery, including orthopedic spine surgeons, neurosurgeons and interventional neuro-radiologists.



Our U.S. sales organization is currently comprised of 122 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. Our 122 U.S. sales professionals are led by 17
regional sales managers, three area directors and a vice president of sales. 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 initiated a spine education specialist program whereby selected representatives will call on primary care physicians to educate them about our instruments. This program consists of 40
spine education specialistsled by four regional managers, and a program director.



Our European operations are headquartered in Belgium with direct sales organizations in the major European countries. We anticipate continuing to build direct sales organizations in the major European countries while
establishing distributor or agency arrangements in smaller ones. We intend to follow a similar model in Europe to the one established in the United States, working with internationally recognized physicians initially as we expand our training,
reimbursement and selling activities.



We are still in the very early stages of
initiating the sales process in selected Asia-Pacific markets. We have initially trained surgeons and sold product in South Korea and China. During 2004, we plan to formulate our clinical and regulatory plans for Japan. In addition, we plan to begin
selling our products in Canada through a direct sales force and in Brazil and Mexico through distributors, and to investigate other selected South American and Asia-Pacific countries regarding potential product registration and selling activities.



Training



We devote significant resources to training and educating physicians in the use of our KyphX instruments. We limit our training and
education of physicians to the specialized skills involved in the proper use of our instruments in the United States, because the FDA has taken the position that we may not train physicians about specific procedures in the spine. Specific procedures
in which our instruments are used commonly involve bone cement to fill the void created by our instruments. Although physicians may use our instruments with bone filler material of their choice, including bone cement, the FDA has taken the position
that we cannot promote the use of bone cement, or train surgeons to use bone cement, with our instruments unless bone cement is specifically approved or cleared for use in the spine. We instruct our trainers, both physician faculty consultants and
employees, not to discuss the use of any bone filler material, including bone cement, with our instruments. However, if unsolicited questions are posed by surgeons during training, we inform surgeons of the regulatory status of bone cement and its
use with our products. Although we believe our training methods are proper, if the FDA determines that our training constitutes promotion of an unapproved use, they could request that we modify our training or subject us to regulatory enforcement.



Reimbursement



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



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Payment for patient care in the United States is generally made by private insurers. These insurers act on their own
behalf or under contract with the U.S. government to administer the Medicare program. Medicare covers most of the medical care expenses of individuals over the age of 64. Approximately 90% of patients with spine fractures caused by osteoporosis are
covered by Medicare, while the rest are covered primarily by private insurers. Private insurers often follow the coverage and payment policies of Medicare.



For inpatient fracture reduction procedures, Medicare pays the hospital a prospectively determined amount based primarily on the patients diagnosis and the nature
of the care provided during the hospital stay. We receive payment from the hospital for our instruments, and Medicare reimburses the hospital under this reimbursement system for its costs of admitting and treating the patient, including the purchase
of our instruments, under existing applicable codes. The surgeon who performs the procedure is reimbursed under a different system that is based on procedure codes, called current procedural terminology, or CPT, codes. Currently, Medicare reimburses
physicians who use our KyphX instruments on a state-by-state basis. This form of reimbursement is not uniform across all states because there is no national CPT code or associated national payment rate relating to procedures using our
instruments. As a result, unless a state has a published policy regarding reimbursement, physicians must report procedures using our instruments under an unlisted CPT code, submit their bills for review and request payment based on the time, work
and risk involved in the procedure. We intend to continue to use the results of future clinical studies, peer-reviewed physician journal articles, and support from leading physicians who are familiar with our KyphX instruments to further
support physician reimbursement for procedures using our instruments. In addition, it is possible that medical societies familiar with the kyphoplasty procedure will apply for the establishment of a national payment rate through a CPT code. Based on
our understanding of this process, it is not anticipated that a national CPT could be established prior to 2006, if at all. We cannot assure you that establishment of a national CPT code, if that ever happens, would be beneficial to our business
since the reimbursement level associated with the national CPT code could be less than what surgeons in some states are presently receiving.



Manufacturing



We inspect, assemble, test, package and sterilize components that have been manufactured by us, or to our specifications by outside contractors. We inspect each lot of components and finished instruments to determine
compliance with our specifications.



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. We obtained our CE Mark in February 2000, and our facility is ISO 9001/EN
46001/ISO 13485 certified. We are subject to unannounced inspections by the FDA and the Food and Drug Branch of the California Department of Health Services, or CDHS, and these inspections may include the manufacturing facilities of our
subcontractors. We have been inspected by the CDHS, the FDA and European auditors and there have been no significant audit findings as a result of these inspections.



In March 2004, we anticipate moving to our new headquarters facility also in Sunnyvale, California. We will be required to update our CDHS
license as it relates to the move to our new facility.



Most 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 related instruments with the exception that we are presently sourcing our KyphX Inflation Syringe from a single supplier. Although additional
suppliers have been possibly identified at this time, none have been appropriately qualified.



We are currently increasing our manufacturing capabilities as we increase commercialization efforts. Manufacturers often experience difficulties in scaling up production, including problems with production yields and
quality control and assurance.



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Research and Development



As of December 31, 2003, we had 22 employees dedicated to research and development. The acquisition of Sanatis added two employees to our research and development
team; their efforts are primarily focused on developing biomaterials for use with our instruments. The research and development group creates 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 for use in orthopedic applications, including but not necessarily limited to treatment of spine fractures. In addition, we intend to
further develop balloon and related technologies to treat various other bone disorders arising from trauma or cancer. We are currently developing the following products:



| |  | additional instruments to facilitate the use of our products in fractures that are particularly difficult to repair;
| | - | --------------------------------------------------------------------------------------------------------------------



| |  | optimized delivery systems for bone void fillers;
| | - | -------------------------------------------------



| |  | Kyphon-branded ceramic biomaterials for use as bone void fillers;
| | - | -----------------------------------------------------------------



| |  | Kyphon-branded acrylic cement for use as a bone void filler;
| | - | ------------------------------------------------------------



| |  | instruments targeted to facilitate repair in smaller vertebral bodies; and
| | - | --------------------------------------------------------------------------



| |  | balloon designs and instruments that cause a balloon to inflate differentially and/or preferentially.
| | - | -----------------------------------------------------------------------------------------------------



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. We also are beginning to see entry into the marketplace of instruments designed to create voids in
vertebral bodies without any attempt at fracture reduction, which are marketed as a safer alternative to vertebroplasty and a less expensive alternative than our KyphX products. Competition among these companies is likely to increase the
awareness and frequency of vertebroplasty and other alternative procedures. We are also beginning to see introduction by competitors of instruments possibly designed to achieve fracture reduction. Particularly in Europe, these products are initially
being marketed as more effective and less expensive than our KyphX products. Numerous companies are developing and marketing materials, including biomaterials, that may be used as bone filler materials. Given the early stage of many of these
competitive marketing efforts, it would be premature to determine what, if any, impact these products may have on our sales growth.



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



Any products that we commercialize will be subject to intense competition. Overall, we believe the primary competitive factors that affect
our instruments are cost, 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, many of these competitors have significantly greater experience and reputations than we do in their respective
fields. Our ability to compete successfully will depend on our ability to develop proprietary instruments that reach the market in a timely manner, receive adequate reimbursement and are safer, less invasive and less expensive than alternatives
available for the same condition. Because of the size of the potential market, we anticipate that companies will dedicate significant resources to developing competing 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 would constitute a significant distraction to our executive team.



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In addition, our products compete with conventional spinal instrumentation in the market for traumatic fracture fixation.



Patents and Proprietary Technology



We believe that in order to have a competitive advantage, we must develop, maintain and
protect proprietary aspects of our technologies. As of December 31, 2003, we had 27 issued U.S. patents, 26 issued foreign patents, 40 pending U.S. patent applications, 140 pending foreign applications and 25 patents that were exclusively licensed
from Bonutti Research in August 2002.



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



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



We require our employees, consultants and advisors to execute confidentiality agreements in connection with their employment, consulting or advisory relationships with us. We also require our employees, consultants
and advisors who we expect to work on our products to agree to disclose and assign to us all inventions conceived during the work day, using our property or which relate to our business. Despite any measures taken to protect our intellectual
property, unauthorized parties may attempt to copy aspects of our products or to obtain and use information that we regard as proprietary. Finally, our competitors may independently develop similar technologies. 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 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 infringe their patents.



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 will perform:



| |  | product design and development;
| | - | -------------------------------



| |  | product testing;
| | - | ----------------



| |  | product manufacturing;
| | - | ----------------------



| |  | product labeling;
| | - | -----------------



| |  | product storage;
| | - | ----------------



| |  | premarket clearance or approval;
| | - | --------------------------------



| |  | advertising and promotion; and
| | - | ------------------------------



| |  | product sales and distribution.
| | - | -------------------------------



Some of the medical devices that we wish to commercially distribute in the United States require either 510(k) clearance or premarket approval from the FDA prior to
marketing. Devices deemed to pose



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relatively less risk are placed in either class I or II, which requires the manufacturer to submit a premarket
notification requesting permission for commercial distribution; this is known as 510(k) clearance. Some low-risk devices are exempted from this requirement. Devices deemed by the FDA to pose the greatest risk, such as life-sustaining,
life-supporting or implantable devices, or devices deemed not substantially equivalent to a previously 510(k)-cleared device, are placed in class III requiring premarket approval, known as a PMA.



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 a conventional bone tamp for the reduction of fractures and/or the creation of a void in cancellous bone in the spine, hand, tibia, radius and calcaneus. The KyphX Xpander Inflatable Bone Tamp is marketed pursuant to the
510(k) clearance for the KyphX Inflatable Bone Tamp. 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, and KyphX Bone Filler Device, when sold as manual orthopedic surgical instruments, are exempt from clearance or approval requirements. Our
products are not cleared for any specific surgical procedure or for use with bone cement in the spine. However, we have recently submitted a 510(k) for clearance of our bone cement KyphX HV-R that we currently sell in Europe. Our current
510(k) clearance does not permit us to promote any particular benefits obtained by using our instruments in surgery. Before we can promote the use of bone cement in the spine or make claims regarding the procedures in which our instruments are used,
we need to reach agreement with the FDA on the data required. We may need additional clinical data to support any or all of the marketing applications.



In October 2000, we received a Warning Letter from the FDA challenging our promotional claims that we were making for our KyphX instruments. In that letter and
subsequently, the FDA took the position that our initial 510(k) clearance for the KyphX Inflatable Bone Tamp did not permit us to promote the product for use in any specific sites in the body or for any specific surgical procedures, such as
for kyphoplasty. The FDA also maintained we could not promote any clinical benefits for our products until we submitted and obtained additional regulatory clearances/approvals.



After discussions and correspondence with the FDA, we agreed to abide by these restrictions and revised our promotional campaign
accordingly. Subsequently, we obtained our current 510(k) clearance to promote the KyphX Inflatable Bone Tamp as a conventional bone tamp in the reduction of fracture and/or creation of a void in cancellous bone in the spine, hand, tibia,
radius and calcaneus. Therefore, at the present time, we do not promote any treatment benefit of, or promote, or train physicians in, any specific surgical procedures involving the use of our instruments or the use of our instruments with bone
cement in the spine. In order to do so, we must first be able to reach agreement with FDA on whether additional clinical data must be generated to support marketing applications for these claims. The failure to obtain FDA approval of treatment
benefits using our cleared products in specific procedures may significantly impair our ability to promote our products.



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In October 2002, the FDA published a Public Health Web Notification entitled Complications Related to the Use of
Bone Cement in Vertebroplasty and Kyphoplasty Procedures. In April 2003 the FDA published an update to the original notification entitled Complications Related to the Use of Bone Cement in Treating Compression Fractures of the
Spine. The updated notification states that reported complications related to the use of polymethylmethacrylate bone cements to treat compression fractures of the spine, such as soft tissue damage and nerve root pain and compression, have
resulted from leakage of bone cement, and that other complications including pulmonary embolism, respiratory and cardiac failure, abdominal intrusions/ileus and death have been reported. The notification is subject to potential future revision at
the sole discretion of the FDA. The content of any further revised notification cannot be predicted. The notification indicates that the FDA is working with appropriate professional organizations and manufacturers of orthopedic devices to develop a
basis for evaluating the safety and effectiveness of bone cements used to treat compression fractures of the spine. The notification requests that the healthcare community follow established procedures for reporting of deaths or serious injuries
resulting from the use of medical devices, including bone cement. For a further discussion of the FDAs Web Notification, see Factors Affecting Future Operating Results If regulatory authorities find that bone cement should not be used in
the spine, our ability to sell and promote our instruments would be harmed, and our exposure to product liability litigation could increase. in Item 7.



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



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



Clinical Studies. Clinical studies are almost always required to support a
premarket approval application and are sometimes required for a 510(k) premarket notification. These studies may require submission of an application for an 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 for a specific number of patients unless the product is deemed 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, unless they are conducted after marketing approval or clearance has been obtained. These clinical studies will require that we submit, and obtain FDA approval of, an IDE prior to commencing clinical studies. The
results of any clinical studies we do conduct may not be sufficient for us to obtain any additional clearances or approvals or to support additional marketing claims for our devices.



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



| |  | fines, injunctions, and civil penalties;
| | - | ----------------------------------------



| |  | recall or seizure of our products;
| | - | ----------------------------------



| |  | operating restrictions, partial suspension or total shutdown of production;
| | - | ---------------------------------------------------------------------------



| |  | refusing our requests for 510(k) clearance or premarket approval of new products;
| | - | ---------------------------------------------------------------------------------



| |  | withdrawing 510(k) clearance or premarket approvals already granted; and
| | - | ------------------------------------------------------------------------



| |  | criminal prosecution.
| | - | ---------------------



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



International. International sales of medical devices are subject to foreign
government regulations, which vary substantially from country to country. The time required to obtain approval by a foreign country may be longer or shorter than that required for FDA approval, and the requirements may differ. The primary regulatory
authority in Europe is that of the European Union, or EU, which consists of 15 countries encompassing most of the major countries in Europe. Other countries, such as Switzerland, have voluntarily adopted laws and regulations that mirror those of the
EU with respect to medical devices. The EU has adopted numerous directives and standards regulating the design, manufacture, clinical trial, labeling and adverse event reporting for medical devices. Devices that comply with the requirements of a
relevant directive will be entitled to bear CE conformity marking, indicating that the device conforms with 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 the 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. We have certification of our manufacturing facilities to ISO 9001/EN46001 quality system requirements. We had our annual inspection in February 2003 with no non-compliance reports issued,
continuing our facility as ISO 9001/EN46001 certified. While no additional premarket approvals in individual EU countries are required, prior to 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.



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Employees



As of December 31, 2003, we had a total of 441 employees, with 72 people in operations, 24 people in research and development, 221 people in sales and sales
administration, 55 people in general and administrative, 27 people in clinical and regulatory, 33 people in marketing and professional education, and 9 people in reimbursement. None of our employees is 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 on our website at http://www.kyphon.com
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. Such
filings are placed on our website as soon as reasonably possible after they are filed with the SEC.



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|ITEM 2. |  | PROPERTIES
|------- |  | ----------



Our operations are headquartered in a 42,500 square foot building in Sunnyvale, California. In December 2003, we entered into a lease termination agreement to terminate the lease in May 2004 which was otherwise due to
expire in March 2005. In September 2003, we entered into a facility lease agreement for a new corporate headquarters also in Sunnyvale, California, including manufacturing space, to replace our existing facilities. The agreement covers a 107,000
square foot facility for a ten-year period with the lease obligation period beginning March 1, 2004. Under the terms of the lease agreement, we have the option to rent an adjacent existing facility as well as an option to have additional square
footage built and leased to us in the same surrounding campus. We plan to transition from the existing facility into our new facility near the end of the first quarter of 2004.



Our European operations are headquartered in a 4,700 square foot leased facility in Brussels, Belgium. This includes offices, storage and
warehouse facilities. We also have a leased research facility located in Rosbach, Germany. In addition, we have leased sales offices in the major countries in Europe.



|ITEM 3. |  | LEGAL PROCEEDINGS
|------- |  | -----------------



We are not a party to any material litigation.



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



No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year covered by this report.



PART II



|ITEM 5. |  | MARKET FOR THE REGISTRANTS COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
|------- |  | -------------------------------------------------------------------------



We had our initial public offering on May 17, 2002. Our Common Stock is traded 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 since the date of our initial public offering as reported on the Nasdaq National Market:



|                                    |  |      |       |     |   |      
|----------------------------------- |  | ---- | ----- | --- | - | -----
|                                    |  | High |       | Low
|Fiscal Year 2002                    |  |      |       |     |   |      
|Second quarter (since May 17, 2002) |  | $    | 19.30 |     | $ | 14.58
|Third quarter                       |  | $    | 16.28 |     | $ | 10.50
|Fourth quarter                      |  | $    | 12.88 |     | $ | 6.87 
|                                    |  |     
|Fiscal Year 2003                    |  |      |       |     |   |      
|First quarter                       |  | $    | 11.00 |     | $ | 7.64 
|Second quarter                      |  | $    | 14.87 |     | $ | 8.10 
|Third quarter                       |  | $    | 25.85 |     | $ | 15.14
|Fourth quarter                      |  | $    | 29.40 |     | $ | 20.56



As of March 1, 2004, the closing price
of our Common Stock on the Nasdaq National Market was $25.80 per share, and the number of registered stockholders on record was 229.



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.



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In May 2002, we completed our initial public offering, including exercise of the underwriters over-allotment
option, of 6,900,000 shares at an initial public offering price of $15.00 per share, for aggregate cash proceeds of approximately $103.4 million. Our managing underwriters for the offering were U.S. Bancorp Piper Jaffray Inc., Banc of America
Securities LLC and Bear, Stearns & Co. Inc. In connection with the offering, we paid approximately $7.2 million in underwriting discounts and commissions and $1.3 million in other offering costs. After deducting the underwriting discounts and
commissions and the offering costs, our net proceeds from the offering, including the over-allotment option, were approximately $94.9 million. As of December 31, 2003, all proceeds from the offering have been utilized.



The Board of Directors approved a stock repurchase program on November 7, 2002 pursuant to
which up to 2,000,000 shares of our outstanding common stock may be repurchased from time to time. The duration of the repurchase program is open-ended. Under the program, we may purchase shares of common stock through open market transactions at
prices deemed appropriate by management. The purchases will be funded from available working capital. As of December 31, 2003, we had repurchased 30,000 shares pursuant to this repurchase program.



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



|ITEM 6. |  | SELECTED CONSOLIDATED FINANCIAL DATA
|------- |  | ------------------------------------



The following tables reflect selected consolidated financial data derived from our consolidated financial statements for each of the last five years. The consolidated
statement of operations data for the years ended December 31, 2003, 2002 and 2001, and the consolidated balance sheet data as of December 31, 2003 and 2002 are derived from our audited consolidated financial statements included in this report. The
consolidated statement of operations data for the years ended December 31, 2000 and 1999, and the consolidated balance sheet data as of December 31, 2001, 2000 and 1999 are derived from our audited consolidated financial statements not included in
this report. Historical results are not necessarily indicative of future results. The selected financial data set forth below should be read in conjunction with our financial statements, the related notes and Managements Discussion and
Analysis of Financial Condition and Results of Operations included elsewhere in this report.



20



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|                                                  |  |                                          |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |        |  
|------------------------------------------------- |  | ---------------------------------------- | ------- | - | ---- | - | ------- | ---- |  | - | ------- | - |  | ---- | ------- | - |  | - | ------ | -
|                                                  |  | Years Ended December 31,                 |        
|                                                  |  | 2003                                     |         |   | 2002 |   |         | 2001 |  |   | 2000    |   |  | 1999 |        
|                                                  |  | (in thousands, except per share amounts) |        
|Consolidated Statement of Operations Data:        |  |                                          |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |        |  
|Net sales                                         |  | $                                        | 131,028 |   |      | $ | 76,316  |      |  | $ | 36,073  |   |  | $    | 6,076   |   |  | $ | 261    |  
|Cost of goods sold                                |  |                                          | 16,794  |   |      |   | 10,416  |      |  |   | 8,108   |   |  |      | 3,606   |   |  |   | 519    |  
|                                                  |  |                                          |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |        |  
|Gross profit (loss)                               |  |                                          | 114,234 |   |      |   | 65,900  |      |  |   | 27,965  |   |  |      | 2,470   |   |  |   | (258   | )
|                                                  |  |                                          |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |        |  
|Operating expenses:                               |  |                                          |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |        |  
|Research and development                          |  |                                          | 15,237  |   |      |   | 10,145  |      |  |   | 7,859   |   |  |      | 4,516   |   |  |   | 1,996  |  
|Sales and marketing                               |  |                                          | 68,676  |   |      |   | 43,509  |      |  |   | 27,891  |   |  |      | 11,399  |   |  |   | 1,264  |  
|General and administrative                        |  |                                          | 17,348  |   |      |   | 12,540  |      |  |   | 9,720   |   |  |      | 5,343   |   |  |   | 1,875  |  
|Purchased in-process research and development     |  |                                          | 636     |   |      |   | 12,250  |      |  |   |        |   |  |      |        |   |  |   |       |  
|                                                  |  |                                          |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |        |  
|Total operating expenses                          |  |                                          | 101,897 |   |      |   | 78,444  |      |  |   | 45,470  |   |  |      | 21,258  |   |  |   | 5,135  |  
|                                                  |  |                                          |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |        |  
|Income (loss) from operations                     |  |                                          | 12,337  |   |      |   | (12,544 | )    |  |   | (17,505 | ) |  |      | (18,788 | ) |  |   | (5,393 | )
|Interest income (expense) and other, net          |  |                                          | 986     |   |      |   | (2,794  | )    |  |   | (309    | ) |  |      | 1,086   |   |  |   | 222    |  
|                                                  |  |                                          |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |        |  
|Net income (loss) before income taxes             |  |                                          | 13,323  |   |      |   | (15,338 | )    |  |   | (17,814 | ) |  |      | (17,702 | ) |  |   | (5,171 | )
|Benefit for income taxes                          |  |                                          | (14,000 | ) |      |   |        |      |  |   |        |   |  |      |        |   |  |   |       |  
|                                                  |  |                                          |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |        |  
|Net income (loss)                                 |  | $                                        | 27,323  |   |      | $ | (15,338 | )    |  | $ | (17,814 | ) |  | $    | (17,702 | ) |  | $ | (5,171 | )
|                                                  |  |                                          |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |        |  
|Net income (loss) per share:                      |  |                                          |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |        |  
|Basic                                             |  | $                                        | 0.71    |   |      | $ | (0.63   | )    |  | $ | (9.06   | ) |  | $    | (15.55  | ) |  | $ | (12.96 | )
|Diluted                                           |  | $                                        | 0.65    |   |      | $ | (0.63   | )    |  | $ | (9.06   | ) |  | $    | (15.55  | ) |  | $ | (12.96 | )
|Weighted-average shares outstanding:              |  |                                          |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |        |  
|Basic                                             |  |                                          | 38,433  |   |      |   | 24,405  |      |  |   | 1,967   |   |  |      | 1,139   |   |  |   | 399    |  
|                                                  |  |                                          |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |        |  
|Diluted                                           |  |                                          | 42,090  |   |      |   | 24,405  |      |  |   | 1,967   |   |  |      | 1,139   |   |  |   | 399    |  
|                                                  |  |                                          |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |        |  
|                                                  | 
|                                                  |  | As of December 31,                       |        
|                                                  |  | 2003                                     |         |   | 2002 |   |         | 2001 |  |   | 2000    |   |  | 1999 |        
|                                                  |  | (in thousands)                           |        
|Consolidated Balance Sheet Data:                  |  |                                          |         |   |      |   |         |      |  |   |         |   |  |      |         |   |  |   |        |  
|Cash, cash equivalents and short-term investments |  | $                                        | 70,950  |   |      | $ | 71,091  |      |  | $ | 3,352   |   |  | $    | 8,898   |   |  | $ | 25,318 |  
|Working capital (deficit)                         |  |                                          | 86,564  |   |      |   | 83,504  |      |  |   | (5,623  | ) |  |      | 10,213  |   |  |   | 24,725 |  
|Total assets                                      |  |                                          | 154,480 |   |      |   | 101,524 |      |  |   | 18,287  |   |  |      | 15,195  |   |  |   | 26,292 |  
|Convertible promissory notes                      |  |                                          |        |   |      |   |        |      |  |   | 12,000  |   |  |      |        |   |  |   |       |  
|Long-term obligations, net                        |  |                                          |        |   |      |   |        |      |  |   | 43      |   |  |      | 132     |   |  |   | 209    |  
|Redeemable convertible preferred stock            |  |                                          |        |   |      |   |        |      |  |   | 38,024  |   |  |      | 38,024  |   |  |   | 34,156 |  
|Deferred stock-based compensation, net            |  |                                          | (6,435  | ) |      |   | (11,947 | )    |  |   | (16,082 | ) |  |      | (6,781  | ) |  |   | (768   | )
|Total stockholders equity (deficit)              |  | $                                        | 134,250 |   |      | $ | 91,514  |      |  | $ | (37,667 | ) |  | $    | (25,134 | ) |  | $ | (9,014 | )



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|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, or MD&A, is provided as a supplement to the accompanying consolidated
financial statements and footnotes contained in Item 8 of this report and to provide an understanding of our results of operations, financial condition, and changes in financial condition. This discussion contains forward-looking statements. These
statements are based on our current expectations, assumptions, estimates and projections about our business and our industry, and involve known and unknown risks, uncertainties and other factors that may cause our or our industrys results,
levels of activity, performance or achievement to be materially different from any future results, levels of activity, performance or achievements expressed or implied in or contemplated by the forward-looking statements. Our actual results and the
timing of selected events could differ materially from those anticipated in these forward-looking statements as a result of selected factors, including those set forth in this section. MD&A is organized as follows:



| | Executive summary.This section provides a general description and history of our business, a brief discussion of our product lines and the opportunities, challenges and
risks we focus on in the operation of our business.
|- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | Results of operations.This section provides our analysis and outlook for the significant line items on our consolidated statement of operations.
|- | ------------------------------------------------------------------------------------------------------------------------------------------------



| | Deferred stock-based compensation.This section provides the method and financial reporting of our accounting for stock options granted to employees prior to our initial
public offering and grants to non-employees.
|- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | Seasonality.This section describes the effects of seasonality on our business.
|- | ------------------------------------------------------------------------------



| | Liquidity and capital resources.This section provides an analysis of our liquidity and cash flows, as well as a discussion of our commitments that existed as of December 31,
2003.
|- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | Recent accounting pronouncements. This section describes the issuance and effects of new accounting pronouncements.
|- | -------------------------------------------------------------------------------------------------------------------



| | Critical accounting policies and estimates.This section discusses those accounting policies that both are considered important to our financial condition and results of
operations, and require us to exercise subjective or complex judgments in their application. In addition, all of our significant accounting policies, including our critical accounting policies, are summarized in Note 2 to our consolidated financial
statements.
|- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | Factors affecting future operating results.This section discusses the most significant factors that could affect our future financial results. The factors discussed in this
section are in addition to factors that may be described in the MD&A captions discussed above and elsewhere in this report.
|- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Executive Summary



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



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##### Table of Contents

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



In recent history, we have had several significant developments, including the following:



| | In May 2000, we commercially launched our KyphX product line to repair vertebral compression fractures of the spine caused primarily by osteoporosis.
|- | -----------------------------------------------------------------------------------------------------------------------------------------------------



| | On May 29, 2002, we completed our initial public offering (IPO), issuing 6,900,000 shares of voting common stock at $15.00 per share. The net proceeds of the IPO were
$94.9 million after deducting underwriting discounts and offering costs.
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | In August 2002, we entered into a patent license agreement with Bonutti Research Inc. for exclusive rights, now totaling 25 listed U.S. patents related to claimed inventions
including expandable balloons and related products for use in the spine and non-exclusive rights in other areas.
|- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | In February 2003, we purchased Sanatis for a total of $4.9 million. Sanatis is a developer and manufacturer of orthopedic biomaterials in Rosbach, Germany.
|- | -----------------------------------------------------------------------------------------------------------------------------------------------------------



Principle Products and Significant Business Trends.Our net sales include
sales of our KyphX instruments consisting of our KyphX Inflatable Bone Tamps, KyphX Inflation Syringe, KyphX Bone Access Systems, KyphX Bone Filler Device, and our KyphX Bone Biopsy Device.



During 2003, our business experienced significant growth. Net sales in 2003 increased to
$131.0 million, compared to $76.3 million in 2002, representing growth of 72%. We introduced 12 new products during 2003, including our own biomaterials, KyphX HV-RandKyphOs, in Europe. Many of the new products were variations of the
existing products, and included additional sizes and/or balloon configurations that give surgeons more options during the procedure.



We trained approximately 1,200 physicians during 2003 in the Unites States and Europe. In the U.S. alone, we added approximately 400 new hospitals to our customer base.
We also initiated a program whereby additional spine education specialists were hired with a primary role of educating referring physicians about surgical options to treating patients with vertebral compression fractures.



In the fourth quarter of 2003, we submitted a 510(k) application to the FDA for our
proprietary bone cement, KyphX HV-R. In addition, we received CE Mark approval in Europe for our calcium phosphate bone filler material, KyphOs. We believe this new biomaterial will allow us to address a portion of the overall
traumatic vertebral compression market in Europe and we will initiate some trial cases early in 2004. Also in Europe during 2003, we began a randomized clinical trial of kyphoplasty with KyphX HV-R compared to conservative therapy with
primarily bracing, bed rest and pain medication. We expect to continue to enroll patients into this trial during 2004.



In 2003, we experienced our first year of overall profitability, as we leveraged our sales growth while continuing to make investments in our product development, sales
and marketing areas. As of December 31, 2003, however, we still had an accumulated deficit of approximately $32.7 million. Expanded activities related to the continued commercialization of our KyphX instruments, enhanced physician
reimbursement and increased product offerings, together with our general and administrative efforts will continue to cause our expenses to increase. As we proceed with commercialization, we will require additional sales and marketing resources, data
from proposed clinical and marketing studies and greater physician reimbursement acceptance by payors. In 2004, we expect continued aggressive growth across our organization to support our expanding business. Managing that growth will be important
to maintaining and increasing our profitability. We also intend to invest significantly in our foreign operations to continue our geographic expansion.



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##### Table of Contents

As we have previously announced, we presently anticipate moving our U.S. headquarters around the end of the first quarter
of 2004 from our present location in Sunnyvale, California to another location about a mile away. We have already terminated our present lease on our current facilities in advance of this move, taking a $1.2 million charge included in general and
administrative expenses in the fourth quarter of 2003. We must vacate our present buildings no later than May 2004.



We have had several recent encouraging developments related to reimbursement for our products. First, the Centers for Medicare and Medicaid Services (CMS) ICD-9
Coordination and Maintenance Committee issued and published a recommendation for a specific ICD-9 code for the kyphoplasty procedure. This ICD-9 code became effective in October 2003 and officially recognizes kyphoplasty as a procedure by CMS. There
was also progress in surgeon reimbursement during the year, and policy and/or bulletin coverage is now established in 39 states, with the remaining states providing coverage on a case-by-case basis. The private pay community has also shown
significant interest in establishing reimbursement policies for kyphoplasty. Specifically, Blue Cross Blue Shield has now adopted policy coverage for kyphoplasty in 17 states, and a number of private payors nationwide have also adopted policy
coverage. On a national level, the Healthcare Common Procedure Coding System (HCPCS) National Editorial Panel established two new HCPCS S codes for kyphoplasty effective January 1, 2004. These S codes are intended for use by private
payors, such as the Blue Cross Blue Shield Association and the Health Insurance Association of America, although no payment level is associated with these codes. In addition, in Europe, kyphoplasty was assigned a code in the newly implemented German
DRG system.



There are many private payors that continue to perceive the
procedure which uses our products as experimental. Another challenge we face is to achieve consistent and/or increased payment levels among the different insurers.



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



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



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##### Table of Contents

Results of Operations



Comparison of years ended December 31, 2003, 2002 and 2001



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:



|                                              |  |                          |         |   |               |     |    |        |   |         |               |  |     |        |  |   |               |   |  |     |   
|--------------------------------------------- |  | ------------------------ | ------- | - | ------------- | --- | -- | ------ | - | ------- | ------------- |  | --- | ------ |  | - | ------------- | - |  | --- | --
|                                              |  | Years Ended December 31, |        
|                                              |  | 2003                     |         |   | 2002          |     |    | 2001   |  
|                                              |  | Amount                   |         |   | % ofNet sales |     |    | Amount |   |         | % ofNet sales |  |     | Amount |  |   | % ofNet sales |  
|U.S. sales                                    |  | $                        | 118,422 |   |               | 90  | %  |        | $ | 70,850  |               |  | 93  | %      |  | $ | 35,418        |   |  | 98  | % 
|International sales                           |  |                          | 12,606  |   |               | 10  | %  |        |   | 5,466   |               |  | 7   | %      |  |   | 655           |   |  | 2   | % 
|                                              |  |                          |         |   |               |     |    |        |   |         |               |  |     |        |  |   |               |   |  |     |   
|Net sales                                     |  |                          | 131,028 |   |               | 100 | %  |        |   | 76,316  |               |  | 100 | %      |  |   | 36,073        |   |  | 100 | % 
|Cost of goods sold                            |  |                          | 16,794  |   |               | 13  | %  |        |   | 10,416  |               |  | 14  | %      |  |   | 8,108         |   |  | 22  | % 
|                                              |  |                          |         |   |               |     |    |        |   |         |               |  |     |        |  |   |               |   |  |     |   
|Gross profit                                  |  |                          | 114,234 |   |               | 87  | %  |        |   | 65,900  |               |  | 86  | %      |  |   | 27,965        |   |  | 78  | % 
|                                              |  |                          |         |   |               |     |    |        |   |         |               |  |     |        |  |   |               |   |  |     |   
|Operating expenses:                           |  |                          |         |   |               |     |    |        |   |         |               |  |     |        |  |   |               |   |  |     |   
|Research and development                      |  |                          | 15,237  |   |               | 12  | %  |        |   | 10,145  |               |  | 13  | %      |  |   | 7,859         |   |  | 22  | % 
|Sales and marketing                           |  |                          | 68,676  |   |               | 52  | %  |        |   | 43,509  |               |  | 57  | %      |  |   | 27,891        |   |  | 77  | % 
|General and administrative                    |  |                          | 17,348  |   |               | 13  | %  |        |   | 12,540  |               |  | 17  | %      |  |   | 9,720         |   |  | 27  | % 
|Purchased in-process research and development |  |                          | 636     |   |               | 1   | %  |        |   | 12,250  |               |  | 16  | %      |  |   |              |   |  |    |   
|                                              |  |                          |         |   |               |     |    |        |   |         |               |  |     |        |  |   |               |   |  |     |   
|Total operating expenses                      |  |                          | 101,897 |   |               | 78  | %  |        |   | 78,444  |               |  | 103 | %      |  |   | 45,470        |   |  | 126 | % 
|                                              |  |                          |         |   |               |     |    |        |   |         |               |  |     |        |  |   |               |   |  |     |   
|Income (loss) from operations                 |  |                          | 12,337  |   |               | 9   | %  |        |   | (12,544 | )             |  | (16 | )%     |  |   | (17,505       | ) |  | (48 | )%
|Other and interest income (expense), net      |  |                          | 986     |   |               | 1   | %  |        |   | (2,794  | )             |  | (4  | )%     |  |   | (309          | ) |  | (1  | )%
|                                              |  |                          |         |   |               |     |    |        |   |         |               |  |     |        |  |   |               |   |  |     |   
|Net income (loss) before income taxes         |  |                          | 13,323  |   |               | 10  | %  |        |   | (15,338 | )             |  | (20 | )%     |  |   | (17,814       | ) |  | (49 | )%
|Benefit for income taxes                      |  |                          | (14,000 | ) |               | (11 | )% |        |   |        |               |  |    |        |  |   |              |   |  |    |   
|                                              |  |                          |         |   |               |     |    |        |   |         |               |  |     |        |  |   |               |   |  |     |   
|Net income (loss)                             |  | $                        | 27,323  |   |               | 21  | %  |        | $ | (15,338 | )             |  | (20 | )%     |  | $ | (17,814       | ) |  | (49 | )%
|                                              |  |                          |         |   |               |     |    |        |   |         |               |  |     |        |  |   |               |   |  |     |   



Net Sales. Net sales
increased $54.7 million, or 72%, in 2003 compared to 2002, and increased $40.2 million, or 112%, in 2002 compared to 2001. The increases in net sales resulted from an increase in the number of trained physicians as well as an increase in the number
of procedures performed by these trained physicians. The increase in international sales also reflected the currency impact of $1.9 million in 2003 as the Euro exchange rate continued to strengthen against the U.S. dollar. No customer accounted for
more than 10% of total net sales in 2003, 2002 and 2001. As of December 31, 2003, we had trained approximately 2,900 surgeons in the U.S. and approximately 900 surgeons in Europe. We believe the total number of potential physicians who can be
trained for the use of our products is approximately 5,000 to 5,500 in the U.S. The number of trainable physicians in Europe is less well defined at this time, but we believe them to be more than 3,000.



Cost of Goods Sold. Cost of goods sold consists of material, labor,
subcontract, and overhead costs. Cost of goods sold increased $6.4 million, or 61%, in 2003 compared to 2002, and increased $2.3 million, or 28%, in 2002 compared to 2001. However, cost of goods sold as a percentage of net sales continue to decrease
primarily as a result of fixed overhead costs being spread over increased production volume. The absolute increase in cost of goods sold over the years from 2001 to 2003 resulted primarily from increased material, labor, subcontract, overhead costs
and inventory provisions in relation to the increased sales volume of our products. Our cost of goods sold and corresponding gross profit percentages can be expected to fluctuate in future periods depending upon changes in our product sales mix and
prices, distribution channels and geographies, manufacturing yields, period expenses and levels of production volume.



Research and Development. Research and development expenses consist of costs of product research, product development, regulatory and clinical functions and
personnel. Research and development expenses increased $5.1 million, or 50%, in 2003 compared to 2002. Research and development expenses increased $2.3 million, or 29%, in 2002 compared to 2001. The increase in 2003 from 2002 was primarily
attributable to increased personnel costs of $1.7 million, increased research and development consulting fees of $858,000, increased product testing and development expenditures of $831,000, and increased basic and applied research funding of
$582,000. The increase in 2002 from 2001 was primarily attributable to increased personnel costs of $1.0 million, increased amortization of deferred stock-based compensation of $832,000 and increased product testing and development expenditures of
$429,000. We expect to continue to make substantial investments in research and development and anticipate that research and development expenses in 2004 will increase in absolute dollars. As a percentage of net sales, we anticipate our research and
development expenses to be in the range of 11% to 12% for 2004.



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Sales and Marketing. Sales and marketing expenses consist of costs for personnel, physician training
programs and marketing activities. Sales and marketing expenses increased $25.2 million, or 58%, in 2003 compared to 2002. Sales and marketing expenses increased $15.6 million, or 56%, in 2002 compared to 2001. The increase in 2003 from 2002 related
primarily to a $17.1 million increase in the costs of hiring, training and compensating additional direct selling representatives, increased expenditures related to advertising, promotion, trade shows and market research activities of $4.0 million,
increased sales travel expenses of $2.0 million, and increased consulting expenses of $1.3 million. The increase in 2002 from 2001 related primarily to a $9.2 million increase in the costs of hiring, training and compensating additional direct
selling representatives, increased expenditures related to advertising, promotion, trade shows and market research activities of $2.6 million, increased sales travel expenses of $1.5 million, and increased amortization of deferred stock-based
compensation of $1.1 million. As we continue to commercialize our KyphX instruments during 2004, we expect to significantly increase our sales and marketing efforts and expenditures in absolute dollars while reducing our sales and marketing
expenses as a percentage of net sales to between 48% to 50% for the year.



General and Administrative. General and administrative expenses consist of personnel costs, professional service fees, expenses related to intellectual property rights and general corporate expenses. General and administrative
expenses increased $4.8 million, or 38%, in 2003 compared to 2002. General and administrative expenses increased $2.8 million, or 29%, in 2002 compared to 2001. The increase in 2003 from 2002 resulted primarily from increased personnel costs of $1.5
million, increased office expenses of $587,000, increased licenses and insurance expenditures of $581,000, increased travel and entertainment expenses of $552,000, and facility expense of $1.2 million due to the termination of the current lease as a
result of our decision to move to a larger new facility. The increases in expenses were offset partially by decreased amortization of deferred stock-based compensation of $337,000. The increase in 2002 from 2001 resulted primarily from increased
personnel costs of $1.0 million, including $500,000 in accrued severance cost, increased miscellaneous taxes, licenses and insurance expenditures of $1.0 million and increased legal, public company expenses, accounting and consulting fees of
$845,000 offset partially by decreased amortization of deferred stock-based compensation of $910,000. We expect general and administrative expenses to increase in the future as we add personnel, continue to expand our patent portfolio and incur
public reporting, governmental compliance and investor-related expenses as a public company. Therefore, we anticipate that our general and administrative expenses will increase in absolute dollars as we expand our infrastructure. However, as a
percentage of net sales, we expect that our general and administrative expenses will decrease slightly during 2004.



Purchased In-Process Research and Development.In February 2003, we purchased Sanatis GmbH (Sanatis), for approximately $4.7 million in
cash and acquisition costs of $201,000. Sanatis is a privately-held developer and manufacturer of orthopedic biomaterials based in Rosbach, Germany. The acquisition was made to add Sanatis experience developing and manufacturing orthopedic
biomaterials and to complement our existing patent portfolio with Sanatis intellectual property surrounding calcium-based biomaterials and delivery technologies. The impact to our financial operating results during 2003 was an increase in
research and development expenses of approximately $624,000. We have recorded the transaction using the purchase method of accounting. As a result of this transaction, we recorded an expense associated with the purchase of in-process research and
development of $636,000, and capitalized net tangible assets of $176,000, intangible assets of $142,000 and goodwill of $4,072,000. We are amortizing the intangible assets on a straight line basis over a five-year period. No amortization of goodwill
has been recorded. Instead, we will perform an assessment for impairment by applying a fair-value based test annually, or more frequently, if changes in circumstances or the occurrence of events suggests the remaining value is not recoverable.



In August 2002, we entered into a patent license agreement with Bonutti
Research Inc. for the rights to a series of patents, now numbering 25, issued to Dr. Peter Bonutti and other related patent rights and applications defined in the agreement. Under the terms of the agreement, we acquired the exclusive right to
develop any of the claimed inventions, including expandable balloons and related products, for use within



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bone, and for use within joints, ligaments, tendons, or cartilage in the spine and the co-exclusive right to develop any
of the claimed inventions, including expandable balloons and related products, for orthopedic use in treating or diagnosing injuries of the joints, ligaments, cartilage, nerves or tendons outside of the spine. We paid $12.3 million in cash for the
rights, all of which was immediately expensed to purchased in-process research and development. The acquisition cost was immediately expensed to operations as the technology acquired may be used to develop products that have not been approved for
sale by regulatory authorities, and the in-process projects to which the patents may apply had not yet reached technological feasibility and had no alternative future uses.



Other and Interest Income (Expense), Net. Other and interest income (expense), net, increased $3.8 million in 2003 compared to
2002. Other and interest income (expense), net, decreased $2.5 million in 2002 compared to 2001. The increase in 2003 from 2002 resulted from interest income from higher cash, cash equivalent and investment balances resulting from proceeds of our
initial public offering as well as decreased interest expense from repaid convertible promissory notes. The decrease in 2002 from 2001 included non-cash interest expense of $3.1 million related to the beneficial conversion feature and the fair value
of warrants issued in connection with the convertible promissory notes. In addition, increased interest expense resulted from outstanding convertible promissory notes offset partially by increased interest income from higher cash, cash equivalent
and investments balances resulting from the proceeds of our initial public offering.



Benefit for Income Taxes. The benefit for income taxes of $14.0 million for fiscal 2003 resulted primarily from a current tax provision of $5.6 million offset by the release of the valuation allowance against our deferred tax
assets in the amount of $21.6 million in the fourth quarter of 2003 as compared to zero in prior years. Historically, we have established deferred tax assets arising from federal and states net operating loss carryforwards, federal and state tax
credit carryforwards as well as from other timing differences. These deferred tax assets have been offset in total by a valuation allowance due to the uncertainty surrounding the realization of such assets. The release of the valuation allowance and
the resulting recognition of a deferred tax benefit in the year was based on managements belief that it is more likely than not that these deferred tax assets will be realized. We believe that in 2004 our tax rate will be approximately 40%,
even though the actual amount of taxes paid may be reduced by net operating loss and research and development tax credit carryforwards as well as deductions due to stock option activities.



At December 31, 2003, we had approximately $34.6 million and $28.9 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 2012 and 2007, respectively, in each case if not utilized.



At December 31, 2003, we had tax credits carryforwards of approximately $1.2 million and $1.3
million for federal and state income tax purposes, respectively. If not utilized, the federal research and development tax credit carryforwards will expire beginning in 2012. The state research and development tax credit can be carried forward
indefinitely.



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



Deferred Stock-Based Compensation



We recorded deferred stock-based compensation for financial reporting purposes as the
difference between the exercise price of options granted to employees and the deemed fair value of our common stock at the time of grant. Deferred stock-based compensation is amortized to cost of goods sold, research and development expense, sales
and marketing expense and general and administrative expense. Deferred stock-based compensation recorded through December 31, 2003 was $18.8 million, with accumulated amortization of $13.4 million. The remaining $5.4 million will be amortized over
the vesting periods of the options, generally four years from the date of grant. All option amounts are being amortized using a



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straight-line method. We expect to record amortization expense for deferred stock-based compensation as follows:



|     |  |        |            
|---- |  | ------ | -----------
|Year |  | Amount
|2004 |  | $      | 3.1 million
|2005 |  | $      | 2.1 million
|2006 |  | $      | 0.2 million



Stock-based compensation expense
related to stock options granted to non-employees is recognized as the stock options are earned. The stock-based compensation expense will fluctuate as the fair market value of our common stock fluctuates. In connection with the grant of stock
options to non-employees, we recorded deferred stock-based compensation of $6.5 million through December 31, 2003, of which $5.4 million has been amortized to expense as of December 31, 2003.



Seasonality



Our business is seasonal in nature. Historically, demand for our products has been the highest in the first and second quarters. 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 holiday schedule during the summer months, and during the fourth quarter, our U.S. revenues reflect
generally the reduced number of selling days due to the holiday season.



Liquidity and Capital Resources



In May 2002, we received net
proceeds of $94.9 million from our initial public offering of common stock. From inception through June 2001, we raised $38.0 million through private sales of redeemable convertible preferred stock. As of December 31, 2003, we had $57.5 million of
cash and cash equivalents, $28.0 million of investments (short and long-term), and working capital of $86.6 million.



Cash Provided by (Used in) Operating Activities. Our operating cash flow in 2003 was primarily the result of our operational profitability. Cash flow from
our increased sales and management of our operating activities more than offset increased working capital needs primarily for accounts receivables. Net cash provided by operations was approximately $13.0 million in 2003 attributable primarily to net
income of $27.3 million and adjustments for non-cash charges related to amortization of deferred stock-based compensation of $6.0 million, increases in accrued liabilities of $7.0 million and accounts payable of $3.0 million as we accrued for income
taxes and increased our operating expenses offset partially by the release of the valuation allowance for the deferred tax asset of $21.6 million and increases in accounts receivable of $11.1 million as we increased our net sales. Our net cash flow
from operations in 2002 reflected a near balance of operational cash inflow versus growing working capital needs. Net cash provided by operating activities was $937,000 in 2002 attributable primarily to the add back of $12.3 million write-off of
in-process research and development charge, non-cash charges related to $6.3 million amortization of deferred stock-based compensation, and $3.1 million of non-cash interest expense offset partially by net loss of $15.3 million, and increases in
accounts receivable and inventories due to increased sales. In 2001, we increased our operating expenditures reflecting our commitment to building our sales and marketing activities, which resulted in a net operating cash outflow. Cash used in
operations was $13.0 million in 2001 attributable primarily to net losses of $17.8 million after adjustment for non-cash charges related to depreciation and amortization of deferred stock-based compensation of $5.2 million, and increases in accounts
receivable and inventories of $4.8 million. These increases in use of cash in operations were offset in part by increases in accounts payable and accrued liabilities of $3.7 million.



Cash Used in Investing Activities. Net cash used in investing activities was $13.3 million, $39.5 million and $1.6 million in
2003, 2002 and 2001, respectively. Cash used in investing activities reflected purchases of property and equipment for all periods. During 2003, cash used for investing activities reflected the net purchases of investments of $4.5 million, and
payment of $4.9 million in connection with the Sanatis acquisition. During 2002, cash used for investing activities reflected the purchases of investments of $24.7 million and payment of $12.3 million in connection with the patent sublicense
agreement. We plan to increase our purchases of property and equipment due to the outfitting of our new Sunnyvale facility in 2004.



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Cash Provided by Financing Activities. Net cash provided by financing activities was $6.6 million,
$85.0 million and $9.1 million in 2003, 2002 and 2001, respectively. Cash provided during 2003 was attributable to proceeds from the issuance of common stock under the employee stock purchase plan of $2.6 million, exercise of stock options of $1.4
million and repayment of related party notes receivable of $2.5 million. Cash provided during 2002 was attributable primarily from proceeds of $94.9 million from issuing common stock in our initial public offering partially offset by repayment of
convertible promissory notes of $13.3 million. Cash provided during 2001 was primarily from the proceeds of convertible promissory notes.



Facility Lease Termination. In December 2003, we entered into a lease termination agreement to terminate the existing facility lease in May 2004
which was due to expire in March 2005. The lease termination charge of $1.2 million was recorded in December 2003 as a general and administrative expense. The amortization of the remaining leasehold improvements in the current facility is being
accelerated to be fully amortized by March 31, 2004.



Contractual Cash
Obligations. At December 31, 2003 we had contractual cash obligations as follows:



|                                   |  |                        |        |      |   |           |  |           |       |            |   |       |  |   |       
|---------------------------------- |  | ---------------------- | ------ | ---- | - | --------- |  | --------- | ----- | ---------- | - | ----- |  | - | ------
|                                   |  | Payment Due by Periods
|                                   |  | Total                  |        | 2004 |   | 2005-2006 |  | 2007-2008 |       | After 2008
|Operating leases                   |  | $                      | 20,271 |      | $ | 1,968     |  | $         | 3,471 |            | $ | 3,677 |  | $ | 11,155
|Purchase obligations               |  |                        | 4,473  |      |   | 4,473     |  |           |      |            |   |      |  |   |      
|                                   |  |                        |        |      |   |           |  |           |       |            |   |       |  |   |       
|Total contractual cash obligations |  | $                      | 24,744 |      | $ | 6,441     |  | $         | 3,471 |            | $ | 3,677 |  | $ | 11,155
|                                   |  |                        |        |      |   |           |  |           |       |            |   |       |  |   |       



The amounts reflected in the table
above for operating leases represent aggregate future minimum lease payments under noncancellable facility leases. Portions of these payments are denominated in foreign currencies and were translated in the tables above based on their respective
U.S. dollar exchange rates at December 31, 2003. These future payments are subject to foreign currency exchange rate risk. In accordance with accounting principles generally accepted in the U.S., our operating leases are not recognized in our
consolidated balance sheet; however, the aggregate minimum lease payments related to these agreements are disclosed in Note 7 to the consolidated financial statements contained in Item 8 of this report, as well as in the table above.



Our purchase obligations relate to the construction and remodeling of our new facility.
Purchase orders or contracts for the purchase of raw materials and other goods and services are not included in the table above. We are not able to determine the aggregate amount of such purchase orders that represent contractual obligations, as
purchase orders may represent authorizations to purchase rather than binding agreements. For the purposes of this table, contractual obligations for purchase of goods or services are defined as agreements that are enforceable and legally binding on
Kyphon and that specify all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. Our purchase orders are based on our current
manufacturing needs and are fulfilled by our vendors within short time horizons. We do not have significant agreements for the purchase of raw materials or other goods specifying minimum quantities or set prices that exceed our expected requirements
for three months. We also enter into contracts for outsourced services; however, the obligations under these contracts were not significant and the contracts generally contain clauses allowing for cancellation without significant penalty.



Off-Balance-Sheet Arrangements. As of December 31, 2003, we did
not have any significant off-balance-sheet arrangements, as defined in Item 303(a)(4)(ii) of SEC Regulation S-K.



Stock Repurchase. The Board of Directors approved a stock repurchase program on November 7, 2002 pursuant to which up to 2,000,000 shares of our outstanding
common stock may be repurchased. The



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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. The purchases will be funded from available working capital. As of December 31, 2003, we had repurchased 30,000 shares pursuant to this repurchase program.



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



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



Recent Accounting Pronouncements



In December 2003, the Financial Accounting Standards Board (FASB) issued a
revised FASB Interpretation No. 46 (FIN 46R), Consolidation of Variable Interest Entities, an interpretation of ARB No. 51. The FASB published the revision to clarify and amend some of the original provisions of FIN 46, which
was issued in January 2003, and to exempt certain entities from its requirements. A variable interest entity (VIE) refers to an entity subject to consolidation according to the provisions of this Interpretation. FIN 46R applies to
entities whose equity investment at risk is insufficient to finance that entitys activities without receiving additional subordinated financial support provided by any parties, including equity holders, or where the equity investors (if any)
do not have a controlling financial interest. FIN 46R provides that if an entity is the primary beneficiary of a VIE, the assets, liabilities, and results of operations of the VIE should be consolidated in the entitys financial statements. In
addition, FIN 46R requires that both the primary beneficiary and all other enterprises with a significant variable interest in a VIE provide additional disclosures. The provisions of FIN 46R are effective for our fiscal 2004 first quarter. We do not
expect the adoption of FIN 46R to have a material impact on our consolidated financial position or results of operations.



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 and our independent auditors. The judgments about those financial estimates are based on information available as of the date of the consolidated financial statements. Those financial policies and estimates include:



Revenue recognition. Our revenue is derived from the sale of products
to customers and distributors. Revenue from product sales, net of discounts, is recognized upon receipt of a valid purchase order, shipment of the products and when collection of the receivables is deemed probable.



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Allowances for doubtful accounts. We make estimates related to the ultimate collection of our accounts receivable.
Specifically, we analyze our accounts receivable, historical bad debt experience, customer concentrations, customer credit-worthiness, and current economic trends, when evaluating the adequacy of our allowance for doubtful accounts. Our provision
for uncollectible accounts receivable has been less than 1% of net sales for each of the years ended December 31, 2003, 2002 and 2001, respectively.



Our accounts receivable balance was $24.6 million and $13.9 million, net of allowances for doubtful accounts of $500,000, and $100,000, respectively, at December 31, 2003
and 2002.



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



Our reserve for excess and obsolete inventory was $625,000 and $607,000 at December 31, 2003 and 2002, respectively.



Accounting for income taxes. We account for income taxes under the provisions of
Statement of Financial Accounting Standards, or SFAS No. 109, Accounting for Income Taxes. Under this method, we determine deferred tax assets and liabilities based upon the difference between the financial statement and tax bases of
assets and liabilities using the enacted tax rates in effect for the year in which the differences are expected to affect taxable income. The tax consequences of most events recognized in the current years financial statements are included in
determining income taxes currently payable. However, because tax laws and financial accounting standards differ in their recognition and measurement of assets, liabilities, equity, revenue, expenses, gains and losses, differences arise between the
amount of taxable income and pretax financial income for a year and between the tax bases of assets or liabilities and their reported amounts in the financial statements. Because it is assumed that the reported amounts of assets and liabilities will
be recovered and settled, respectively, a difference between the tax basis of an asset or a liability and its reported amount in the balance sheet will result in a taxable or a deductible amount in some future years when the related liabilities are
settled or the reported amounts of the assets are recovered, hence giving rise to a deferred tax asset. We must then assess the likelihood that our deferred tax assets will be recovered from future taxable income and to the extent we believe that
recovery is not likely, we must establish a valuation allowance.



As of
December 31, 2002, we had provided a full valuation allowance of $20.4 million against our deferred tax assets, due to uncertainties related to our ability to utilize our deferred tax assets, primarily consisting of certain net operating losses
carried forward, before they expire. In the fourth quarter of 2003, we released our valuation allowance because based upon our recurring level of profitability, we believe that it is more likely than not that we will be able to utilize our deferred
tax assets before they expire.



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As part of the process of preparing our consolidated financial statements, we are required to estimate our income taxes.
This process involves estimating our actual current tax exposure together with assessing temporary differences that may result in deferred tax assets. Management judgment is required in determining any valuation allowance recorded against our
deferred tax assets. Any such valuation allowance would be based on our management estimates of taxable income and the period over which our deferred tax assets would be recoverable.



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



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



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.



Factors Affecting Future Operating Results



Unless we obtain additional regulatory approvals or clearances, we will not be able to promote the use of our instruments in specific surgical procedures or the
benefits of any surgical procedures (including procedures involving bone cement) using our instruments in the United States, and our ability to grow our business could be significantly harmed.



In October 2000, we received a Warning Letter from the FDA challenging the promotional
claims that we were making for our KyphX instruments. The FDA said that our regulatory clearance for the KyphX Inflatable Bone Tamp did not permit us to promote the product for use in any specific sites in the body, or for any specific
surgical procedures, including for kyphoplasty. The FDA also stated that we could not promote any clinical benefits of surgical procedures using our instruments until we obtained additional regulatory approvals related to the benefits. After
discussions and correspondence with the FDA, we agreed to abide by these restrictions and revised our promotional campaign accordingly. Subsequently, we obtained our current 510(k) clearance to promote the KyphX Inflatable Bone Tamp as a
conventional bone tamp in the reduction of fracture and/or creation of a void in cancellous bone in the spine, hand, tibia, radius and calcaneus. In order to promote the use of our devices for specific procedures and with certain resultant patient
benefits, we must obtain further market clearances or approvals, which may require additional clinical data to be generated to support such clearance or approval. If such an application or applications are filed, we can provide no assurance that
they will be approved in a timely fashion, if at all. If we fail to obtain these additional regulatory approvals, our ability to generate revenues may be harmed.



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If regulatory authorities find that bone cement should not be used in the spine, our ability to sell and promote our
instruments would be harmed, and our exposure to product liability litigation could increase.



In October 2002, the FDA published a Public Health Web Notification entitled Complications Related to the Use of Bone Cement in Vertebroplasty and kyphoplasty Procedures. In April 2003 the FDA published an
update to the original notification entitled Complications Related to the Use of Bone Cement in Treating Compression Fractures of the Spine. The updated notification states that reported complications related to the use of
polymethylmethacrylate bone cements to treat compression fractures of the spine, such as soft tissue damage and nerve root pain and compression, have resulted from leakage of bone cement, and that other complications including pulmonary embolism,
respiratory and cardiac failure, abdominal intrusions/ileus and death have been reported. The notification is subject to potential future revision at the sole discretion of the FDA. The content of any further revised notification cannot be
predicted. The notification indicates that the FDA is working with appropriate professional organizations and manufacturers of orthopedic devices to develop a basis for evaluating the safety and effectiveness of bone cements used to treat
compression fractures of the spine. The notification requests that the healthcare community follow established procedures for reporting of deaths or serious injuries resulting from the use of medical devices, including bone cement.



In July 2003, the Medicines and Healthcare Products Regulatory Agency (MHRA) of the United
Kingdom issued a Medical Device Alert entitled, Injectable polymeric cements in percutaneous vertebroplasty, balloon kyphoplasty and pedicle screw augmentation procedures. The UK MHRA has received reports of bone cement leaking during
vertebroplasty and pedicle screw augmentation procedures leading to patient complications. The Alert noted that there have been no complications reported to MHRA from balloon kyphoplasty procedures, but stated that it was including balloon
kyphoplasty procedures in the Alert due to similarities the MHRA perceived exist between balloon kyphoplasty procedures and the other procedures it identified in its Alert. We believe the MHRAs Alert concerning balloon kyphoplasty pertains
directly to our KyphX products, since our products are the only balloons used in Europe to perform kyphoplasty. The notification asks physicians to consider alternatives before performing procedures using bone cement in the spine, to use the
manufacturers instructions in preparing bone cements for use in the spine, and to take specific precautions before and during those procedures.



These notifications themselves may raise concerns with our customers, potential customers and reimbursement organizations, which could negatively impact our ability to
sell and promote our instruments. An increase in reports of deaths or serious injuries could lead the FDA or foreign regulatory agencies to issue safety alerts, health advisories, or mandated labeling changes restricting use of our instruments,
including new warnings regarding their use or contraindicating their use with bone cement. In addition, since use of our products in the spine necessarily causes a surgeon to use a bone void filler of choice, typically bone cement, in the spine to
fill the voids created by our products, increased reporting of adverse events would expose us to increased risk of product liability litigation, and our current insurance coverage limits may not be adequate. Product liability insurance is expensive
and may not be available to us in the future on acceptable terms, if at all.



In the United States, we are not permitted to promote, or train physicians in, the use of ourKyphX instruments with bone cement in the spine.



As the FDAs position is that we may not train physicians about specific procedures in the spine, we limit our training and education
of physicians to the specialized skills involved in the proper use of our instruments. Although physicians may use our instruments with bone filler material of their choice, including bone cement, the FDA has taken the position that we cannot
promote the use of bone cement, or train surgeons to use bone cement with our instruments unless bone cement is specifically approved for use in the spine. We instruct our trainers, both physician faculty consultants and employees, not to discuss
the use of any bone filler material, including bone cement, with our instruments. However, they may respond to unsolicited questions about bone cement that are raised by physician participants during a training



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program. Although we believe our training methods are proper, if the FDA determines that our training constitutes
promotion of an unapproved use, they can request that we modify our training or subject us to regulatory enforcement actions, including the issuance of a warning letter, injunction, seizure, civil fine and criminal penalty.



If we are unable to obtain U.S. regulatory approval to market the use of our bone cement
for use with our instruments in spine fracture surgery or to document resulting benefits, our future competitive position and revenue may be harmed.



In December 2003, we submitted a 510(k) application for clearance of our bone cement as a bone void filler material in a specific minimally invasive spine procedure known
as kyphoplasty. If we fail to receive 510(k) clearance, or as part of the clearance process, we may be required to conduct clinical studies to support our FDA submission(s). There are many risks associated with conducting the clinical study,
including our ability to:



| |  | obtain FDA approval of our study protocol;
| | - | ------------------------------------------



| |  | enroll patients;
| | - | ----------------



| |  | avoid adverse study outcomes; and
| | - | ---------------------------------



| |  | demonstrate safety and effectiveness.
| | - | -------------------------------------



Any of these factors could delay, limit or prevent our successful completion of a clinical study and/or our regulatory approval. If we are unable to obtain clearance or
FDA approval of our bone cement for use in spine surgery, our future competitive position and revenues may be harmed.



If we are unable to demonstrate to regulatory authorities, such as the FDA, the benefits we believe result from the use of our products, we will be unable to
effectively promote the benefits of our products and the medical community may fail to adopt our products as the treatment method of choice for vertebral compression fractures, which could harm our future competitive position and our revenue stream.



Vertebral compression fractures in the past have been treated with a
variety of measures, including vertebroplasty, which involves the high-pressure introduction of bone cement or other bone filler material into the spine without creation of a void in the bone to accept the cement and without attempting to reduce the
fracture before use of the cement. Many in the medical community are not yet persuaded, and may never be persuaded, that the additional steps of creating a void in the vertebral bodies and/or reducing the compression fracture with our products
provide any further patient benefits over those already offered by vertebroplasty, or that any additional benefits associated with spinal deformity correction are worth the additional cost of our instruments. If we are unable to demonstrate that
real benefits result from procedures using our products to the satisfaction of regulatory authorities, including the FDA, we will be unable to promote any of these benefits, and the medical community may not widely adopt use of our products, or may
entirely reject using our products to perform surgery, which would harm our business and our revenues and could significantly affect our growth.



Our failure to obtain or maintain necessary regulatory clearances or approvals could hurt our ability to commercially distribute and market ourKyphXinstruments.



Our KyphX instruments are considered
medical devices and are subject to extensive regulation in the United States and in foreign countries where we intend to do business. Unless an exemption applies, each medical device that we wish to market in the United States must first receive
either 510(k) clearance or premarket approval from the FDA. The FDAs 510(k) clearance process usually takes from three to 12 months, but may take longer. The premarket approval process generally takes from one to three years from the time the
application is filed with the FDA, but it can be longer and can be significantly more expensive than the 510(k) clearance process. Although we have obtained 510(k) clearance for the KyphX Inflatable Bone Tamp for fracture reduction in
specific sites including the spine, hand, tibia, radius and calcaneus, our 510(k) clearance can be revoked if safety or effectiveness problems develop. We also may be required to obtain 510(k) clearance or premarket approval to market additional
instruments and will be required to



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obtain additional clearances/approvals for new indications for our KyphX instruments. Before we can market any
bone cement product for use in spine surgery, we must first obtain regulatory clearance. We cannot be certain that we would obtain any further 510(k) clearances or premarket approvals in a timely manner or at all. Delays in obtaining clearances or
approvals may adversely affect our revenue and future profitability.



Modifications to our marketed devices may require new 510(k) clearances or premarket approvals or 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. 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 instrument, we may be required to cease marketing or to recall the modified device until we obtain clearance or approval, and we may be subject to
significant regulatory fines or penalties.



If we fail to comply with
Quality System regulations, our manufacturing operations could be delayed, and our product sales and profitability could suffer.



Our manufacturing processes and those of our suppliers are required to comply with the FDAs Quality System regulations, which cover the procedures and documentation
of the design, testing, production, control, quality assurance, labeling, packaging, storage and shipping of our instruments. The FDA enforces its Quality System regulations through periodic unannounced inspections. If we fail a Quality System
inspection, our operations could be disrupted and our manufacturing delayed. Failure to take adequate corrective action in response to an adverse Quality System inspection could force a shut-down of our manufacturing operations and/or a recall of
our instruments, which would cause our instrument sales and business to suffer.



If reimbursement for the procedures using our instruments becomes difficult to obtain or is not available in sufficient amounts, our instruments may not be widely adopted.



In a small number of cases, physicians performing a procedure using our instruments have not
been reimbursed. Continued adoption of our instruments by the medical community may be adversely impacted if physicians do not receive sufficient reimbursement from payors for their services in performing the procedures using our instruments.
Currently, there is no specific procedure code under which reimbursement to physicians is available for procedures performed using our KyphX instruments. Physicians must report procedures using our instruments under an unlisted current
procedural terminology, or CPT, code, and hospitals receive reimbursement for an inpatient stay. Physicians have obtained reimbursement from Medicare for the use of our products in all 50 states and in the District of Columbia. However, physicians
in some states believe that the level of reimbursement we have achieved thus far is too low. Until a specific national CPT code is granted, physician reimbursement from Medicare may be harder to obtain in some states. To date, no application for a
national CPT code has been filed and none may be filed for one or more years. In addition, the absence of FDA approval specifically allowing us to promote the use of bone cement in the spine may affect the availability of reimbursement for spine
surgeries in which our instruments are used. Future regulatory action by a government agency, including the adoption of a national CPT code or negative clinical results may diminish reimbursement coverage for both the physician and hospital.
Finally, reimbursement differs from state to state, and some states may not reimburse for a procedure in an adequate amount. If physicians are unable to obtain adequate reimbursement for procedures in which our KyphX instruments are used, we
may be unable to sell our instruments and our business could suffer.



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Adverse changes in reimbursement procedures by domestic and international payors may impact our ability to market and
sell our instruments.



Even if the use of our instruments is reimbursed by
private payors and Medicare, adverse changes in payors policies toward reimbursement for the procedure would harm our ability to market and sell our instruments. We are unable to predict what changes will be made in the reimbursement methods
used by payors. We cannot be certain that under prospective payment systems, such as those utilized by Medicare, and in many managed care systems used by private health care payors, the cost of our instruments will be justified and incorporated into
the overall cost of the procedure.



Even if we fulfill international regulatory
requirements to market our instruments, our success will be partly dependent upon the availability of reimbursement within prevailing health care payment systems. Reimbursement and health care payment systems in international markets vary
significantly by country and include both government-sponsored health care and private insurance. In addition, health care cost containment efforts similar to those we face in the United States are prevalent in many of the other countries in which
we intend to sell our instruments, and these efforts are expected to continue. Although we intend to seek international reimbursement approvals, we may not obtain approvals in a timely manner, if at all.



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



We manufacture medical devices that are used on patients in spine surgery procedures. Spine surgery involves significant risk of serious complications, including
bleeding, nerve injury, paralysis and death. Use of bone filler material by surgeons to fill the void created using our KyphX Inflatable Bone Tamp may also lead to these complications, as a result of leakage of the bone filler material into
the spinal canal or surrounding tissue. Consequently, companies that produce instruments for use in the spine are subject to a significant risk of product liability litigation. If our instruments are found to have caused or contributed to any
injury, we could be held liable for substantial damages, and our current product liability coverage limits may not be adequate to protect us from any liabilities we might incur. In addition, we may require increased product liability coverage if
sales of our instruments increase. Product liability insurance is expensive and may not be available to us in the future on acceptable terms, if at all.



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 our KyphX Inflation
Syringe, as well as other key components necessary for the manufacture of our products. In addition, we are presently sourcing our KyphX Inflation Syringe from a single supplier, without any present viable alternative supplier identified.
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 lead to:



| |  | 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.



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



Our world-wide direct sales organization has increased from 31 employees in October 2000 to over 200 employees in December 2003, which we believe represents very significant growth over a relatively short period of
time. The growth that we have experienced, and in the future may experience, provides challenges to our organization, requiring us to rapidly expand our personnel and manufacturing operations. We may not be able to hire sufficient personnel to meet
our growth goals or may have difficulty managing such rapid growth. As a result, our failure to recruit additional sales personnel may result in our inability to meet our projections. Future growth may strain our infrastructure, operations, product
development and other managerial and operating resources. If our business resources become strained, we may not be able to deliver instruments in a timely manner.



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



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



| |  | longer-standing distribution networks, and relationships with health care providers and payors;
| | - | -----------------------------------------------------------------------------------------------



| |  | additional lines of products, and the ability to bundle products to offer higher discounts or other incentives to gain a competitive advantage; and
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------



| |  | greater resources for product development, sales and marketing and patent litigation.
| | - | -------------------------------------------------------------------------------------



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



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



We believe that the proprietary technology embodied in our instruments and methods gives us a competitive advantage. Maintaining this competitive advantage is important
to our future success. We rely on patent protection in the U.S. and abroad, as well as on a combination of copyright, trade secret and trademark laws, to protect our proprietary technology. However, these legal means afford only limited protection
and may not adequately protect our rights or permit us to gain or keep any competitive advantage. For example, our patents may be challenged, invalidated or circumvented by third parties. Our two earliest patents, which we believe provide broad
protection to our technology but which are so far untested, expire no later than February 2009. Our patent applications may not issue as patents at all or in a form that will be advantageous to us. We may not be able to prevent the unauthorized
disclosure or use of our technical knowledge or other trade secrets by consultants, vendors, former employees and current employees, despite the existence of nondisclosure and confidentiality agreements and other contractual restrictions.
Furthermore, the laws of foreign countries may not protect our intellectual property rights to the same extent as the laws of the United States and may permit others to copy our products without effective recourse. If our intellectual property
rights are not adequately protected, we may be unable to



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keep other companies from competing directly with us, which could result in a decrease in our market share. If we decide
to enforce our intellectual property rights to prevent or inhibit appropriation of our technology by competitors, that process will be expensive and time consuming to litigate or otherwise dispose of and will divert managements attention from
our core business.



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



The medical device industry has been characterized by extensive litigation and administrative proceedings regarding patents and other
intellectual property rights. Whether an instrument infringes a patent involves complex legal and factual issues, the determination of which is often uncertain. Our competitors may assert that our instruments and methods infringe their patents. From
time to time, we may 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 their patents
issued first. Because patent applications can take many years to issue, there may be applications now pending of which we are unaware, which may later result in issued patents that our instruments or methods may infringe. There could also be
existing patents that one or more of our instruments or methods may inadvertently be infringing of which we are unaware. As the number of competitors in the market for minimally invasive spine disorder treatments grow, the possibility of a patent
infringement claim against us increases.



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



We may initiate litigation to protect our intellectual property rights.



We may in the future initiate claims or litigation against third parties for infringement
of our proprietary rights, in order to protect our rights or further determine the scope and validity of our intellectual property protection. We may also begin one or more patent proceedings in various administrative agencies, such as the
worlds various Patent Offices, to protect our patent rights and prevent them from being undermined by our competitors patent filings. These claims and proceedings could result in costly litigation and the diversion of management
attention and resources away from our business and our proprietary rights may be damaged as a result if we do not prevail in any action we initiate, which may harm our ability to protect our business from competition. In addition, our stock price
may decline as a result of the impact of the litigation, including the financial impact of the cost of the litigation, announcements of intermediate results and rulings on various motions, and/or the publics perception of the litigation
progression.



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



With the exception of the larger countries in Europe and in Canada, we sell our KyphX instruments in foreign markets through distributors. To the extent we rely on distributors, our success will depend upon the efforts of others,
over which we may have little control. If we lose a distributor or a distributor fails to perform, our revenues will be harmed.



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



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



| |  | our products may sell at lower prices outside the United States;
| | - | ----------------------------------------------------------------



| |  | agreements may be difficult to enforce;
| | - | ---------------------------------------



| |  | receivables may be difficult to collect through a foreign countrys legal system;
| | - | ---------------------------------------------------------------------------------



| |  | foreign customers may have longer payment cycles;
| | - | -------------------------------------------------



| |  | foreign countries may impose additional withholding taxes or otherwise tax our foreign income, impose tariffs or adopt other restrictions on foreign trade;
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | U.S. export licenses may be difficult to obtain;
| | - | ------------------------------------------------



| |  | intellectual property may be more difficult to acquire and enforce in foreign countries;
| | - | ----------------------------------------------------------------------------------------



| |  | terrorist activity may interrupt distribution channels or impact our customers or employees;
| | - | --------------------------------------------------------------------------------------------



| |  | fluctuations in exchange rates may affect product demand and adversely affect the profitability, in U.S. dollars, of products sold in foreign markets where payments are made in
local currencies.
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Any of these events could harm our operations.



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



We may acquire companies, products or
technologies that we believe to be complementary to our business. If we do so, we may have difficulty integrating the acquired personnel, financials, operations, products or technologies. Acquisitions may dilute our earnings per share, disrupt our
ongoing business, distract our management and employees and increase our expenses, which could harm our business.



Our principal stockholders have significant voting power and may take actions that may not be in the best interests of our other stockholders.



Our officers, directors and principal stockholders together control approximately 52% of our
outstanding common stock as of March 1, 2004. If these stockholders act together, they will be able to control our management and affairs in all matters requiring stockholder approval, including the election of directors and approval of significant
corporate transactions. This concentration of ownership may adversely affect the market price of our common stock. This concentration of ownership may not be in the best interest of our other stockholders.



Our certificate of incorporation and by-laws include a poison pill and other
anti-takeover provisions that 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 shareholders. Those provisions might discourage, delay or prevent a change in the control of our company or a change in our management. The existence of these provisions could adversely affect
the voting power of holders of common stock and limit the price that investors might be willing to pay in the future for shares of our common stock.



|ITEM 7A. |  | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
|-------- |  | ----------------------------------------------------------



Our exposure to interest rate risk at December 31, 2003 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.



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We have operated mainly in the United States, and 90%, 93%, and 98% of our sales were made in U.S. dollars in 2003, 2002,
and 2001, respectively. To date, we have not had any material exposure to foreign currency rate fluctuations. The majority of our European sales is derived from European Union countries and is denominated in 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 (loss). We do not
currently hedge our exposure to foreign currency exchange rate fluctuations.



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|ITEM 8. |  | CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
|------- |  | --------------------------------------------------------



KYPHON INC.

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS



|                                                                                                                     |  |     
|-------------------------------------------------------------------------------------------------------------------- |  | ----
|                                                                                                                     |  | Page
|Consolidated Financial Statements:                                                                                   |  |     
|Report of Independent Auditors                                                                                       |  | 42  
|Consolidated Statements of Operations for the three years ended December 31, 2003, 2002 and 2001                     |  | 43  
|Consolidated Balance Sheets at December 31, 2003 and 2002                                                            |  | 44  
|Consolidated Statements of Cash Flows for the three years ended December 31, 2003, 2002 and 2001                     |  | 45  
|Consolidated Statements of Stockholders Equity (Deficit) for the three years ended December 31, 2003, 2002 and 2001 |  | 46  
|Notes to Consolidated Financial Statements                                                                           |  | 47  
|                                                                                                                     | 
|Financial Statement Schedule:                                                                                        |  |     
|Report of Independent Auditors on Financial Statement Schedule                                                       |  | 67  
|Schedule II Valuation and Qualifying Accounts                                                                        |  | 68  



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REPORT OF INDEPENDENT AUDITORS



The Board of
Directors and Stockholders

Kyphon Inc.



In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Kyphon Inc.
(the Company) and its subsidiaries at December 31, 2003 and 2002 and the results of their consolidated operations and their cash flows for each of the three years in the period ended December 31, 2003 in conformity with accounting
principles generally accepted in the United States of America. These financial statements 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 auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material misstatement. An audit 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.



/s/  PricewaterhouseCoopers LLP



San Jose, California

March 9, 2004





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KYPHON INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share amounts)



|                                              |  |                          |         |   |      |   |         |      |  |   |         |  
|--------------------------------------------- |  | ------------------------ | ------- | - | ---- | - | ------- | ---- |  | - | ------- | -
|                                              |  | Years Ended December 31, |        
|                                              |  | 2003                     |         |   | 2002 |   |         | 2001 | 
|Net sales                                     |  | $                        | 131,028 |   |      | $ | 76,316  |      |  | $ | 36,073  |  
|Cost of goods sold                            |  |                          | 16,794  |   |      |   | 10,416  |      |  |   | 8,108   |  
|                                              |  |                          |         |   |      |   |         |      |  |   |         |  
|Gross profit                                  |  |                          | 114,234 |   |      |   | 65,900  |      |  |   | 27,965  |  
|                                              |  |                          |         |   |      |   |         |      |  |   |         |  
|Operating expenses:                           |  |                          |         |   |      |   |         |      |  |   |         |  
|Research and development                      |  |                          | 15,237  |   |      |   | 10,145  |      |  |   | 7,859   |  
|Sales and marketing                           |  |                          | 68,676  |   |      |   | 43,509  |      |  |   | 27,891  |  
|General and administrative                    |  |                          | 17,348  |   |      |   | 12,540  |      |  |   | 9,720   |  
|Purchased in-process research and development |  |                          | 636     |   |      |   | 12,250  |      |  |   |        |  
|                                              |  |                          |         |   |      |   |         |      |  |   |         |  
|Total operating expenses                      |  |                          | 101,897 |   |      |   | 78,444  |      |  |   | 45,470  |  
|                                              |  |                          |         |   |      |   |         |      |  |   |         |  
|Income (loss) from operations                 |  |                          | 12,337  |   |      |   | (12,544 | )    |  |   | (17,505 | )
|                                              |  |                          |        
|Interest income                               |  |                          | 1,067   |   |      |   | 929     |      |  |   | 179     |  
|Interest expense                              |  |                          | (23     | ) |      |   | (3,672  | )    |  |   | (365    | )
|Other expense                                 |  |                          | (58     | ) |      |   | (51     | )    |  |   | (123    | )
|                                              |  |                          |         |   |      |   |         |      |  |   |         |  
|Net income (loss) before income taxes         |  |                          | 13,323  |   |      |   | (15,338 | )    |  |   | (17,814 | )
|Benefit for income taxes                      |  |                          | (14,000 | ) |      |   |        |      |  |   |        |  
|                                              |  |                          |         |   |      |   |         |      |  |   |         |  
|Net income (loss)                             |  | $                        | 27,323  |   |      | $ | (15,338 | )    |  | $ | (17,814 | )
|                                              |  |                          |         |   |      |   |         |      |  |   |         |  
|Net income (loss) per share:                  |  |                          |         |   |      |   |         |      |  |   |         |  
|Basic                                         |  | $                        | 0.71    |   |      | $ | (0.63   | )    |  | $ | (9.06   | )
|                                              |  |                          |         |   |      |   |         |      |  |   |         |  
|Diluted                                       |  | $                        | 0.65    |   |      | $ | (0.63   | )    |  | $ | (9.06   | )
|                                              |  |                          |         |   |      |   |         |      |  |   |         |  
|Weighted-average shares outstanding:          |  |                          |         |   |      |   |         |      |  |   |         |  
|Basic                                         |  |                          | 38,433  |   |      |   | 24,405  |      |  |   | 1,967   |  
|                                              |  |                          |         |   |      |   |         |      |  |   |         |  
|Diluted                                       |  |                          | 42,090  |   |      |   | 24,405  |      |  |   | 1,967   |  
|                                              |  |                          |         |   |      |   |         |      |  |   |         |  



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



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KYPHON INC.

CONSOLIDATED BALANCE SHEETS

(in thousands, except per share amounts)



|                                                                                                                                                                                |  |              |         |   |      |   |         |  
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------ | ------- | - | ---- | - | ------- | -
|                                                                                                                                                                                |  | December 31, |        
|                                                                                                                                                                                |  | 2003         |         |   | 2002 |  
|Assets                                                                                                                                                                          |  |              |         |   |      |   |         |  
|Current assets:                                                                                                                                                                 |  |              |         |   |      |   |         |  
|Cash and cash equivalents                                                                                                                                                       |  | $            | 57,494  |   |      | $ | 49,867  |  
|Investments                                                                                                                                                                     |  |              | 13,456  |   |      |   | 21,224  |  
|Accounts receivable, net of allowance for doubtful accounts of $500 in 2003 and $100 in 2002                                                                                    |  |              | 24,632  |   |      |   | 13,934  |  
|Inventories                                                                                                                                                                     |  |              | 6,239   |   |      |   | 4,416   |  
|Prepaid expenses and other current assets                                                                                                                                       |  |              | 3,810   |   |      |   | 4,073   |  
|Deferred tax assets                                                                                                                                                             |  |              | 1,163   |   |      |   |        |  
|                                                                                                                                                                                |  |              |         |   |      |   |         |  
|Total current assets                                                                                                                                                            |  |              | 106,794 |   |      |   | 93,514  |  
|                                                                                                                                                                                |  |             
|Investments                                                                                                                                                                     |  |              | 14,529  |   |      |   | 3,212   |  
|Property and equipment, net                                                                                                                                                     |  |              | 6,044   |   |      |   | 4,265   |  
|Goodwill and other intangible assets, less accumulated amortization of $26 in 2003                                                                                              |  |              | 4,722   |   |      |   |        |  
|                                                                                                                                                                                | 
|Deferred tax assets                                                                                                                                                             |  |              | 20,462  |   |      |   |        |  
|Other assets                                                                                                                                                                    |  |              | 1,929   |   |      |   | 533     |  
|                                                                                                                                                                                |  |              |         |   |      |   |         |  
|Total assets                                                                                                                                                                    |  | $            | 154,480 |   |      | $ | 101,524 |  
|                                                                                                                                                                                |  |              |         |   |      |   |         |  
|Liabilities and Stockholders Equity                                                                                                                                            |  |              |         |   |      |   |         |  
|Current liabilities:                                                                                                                                                            |  |              |         |   |      |   |         |  
|Accounts payable                                                                                                                                                                |  | $            | 5,531   |   |      | $ | 2,518   |  
|Accrued liabilities                                                                                                                                                             |  |              | 14,699  |   |      |   | 7,492   |  
|                                                                                                                                                                                |  |              |         |   |      |   |         |  
|Total current liabilities                                                                                                                                                       |  |              | 20,230  |   |      |   | 10,010  |  
|                                                                                                                                                                                |  |              |         |   |      |   |         |  
|Commitments and contingencies (Note 7)                                                                                                                                          |  |              |         |   |      |   |         |  
|                                                                                                                                                                                |  |             
|Stockholders equity:                                                                                                                                                           |  |              |         |   |      |   |         |  
|Preferred stock, par value: $0.001 Authorized: 5,000 shares; none issued and outstanding                                                                                        |  |              |        |   |      |   |        |  
|Common stock, par value: $0.001 Authorized: 120,000 shares Issued: 39,470 shares in 2003 and 37,360 shares in 2002 Outstanding: 39,440 shares in 2003 and 37,330 shares in 2002 |  |              | 39      |   |      |   | 37      |  
|Additional paid-in capital                                                                                                                                                      |  |              | 171,359 |   |      |   | 163,354 |  
|Treasury stock, at cost: 30 shares in 2003 and 2002                                                                                                                             |  |              | (201    | ) |      |   | (201    | )
|Deferred stock-based compensation, net                                                                                                                                          |  |              | (6,435  | ) |      |   | (11,947 | )
|Accumulated other comprehensive income                                                                                                                                          |  |              | 2,196   |   |      |   | 302     |  
|Accumulated deficit                                                                                                                                                             |  |              | (32,708 | ) |      |   | (60,031 | )
|                                                                                                                                                                                |  |              |         |   |      |   |         |  
|Total stockholders equity                                                                                                                                                      |  |              | 134,250 |   |      |   | 91,514  |  
|                                                                                                                                                                                |  |              |         |   |      |   |         |  
|Total liabilities and stockholders equity                                                                                                                                      |  | $            | 154,480 |   |      | $ | 101,524 |  
|                                                                                                                                                                                |  |              |         |   |      |   |         |  



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



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KYPHON INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)



|                                                                                                   |  |                          |         |   |      |   |         |      |  |   |         |  
|-------------------------------------------------------------------------------------------------- |  | ------------------------ | ------- | - | ---- | - | ------- | ---- |  | - | ------- | -
|                                                                                                   |  | Years Ended December 31, |        
|                                                                                                   |  | 2003                     |         |   | 2002 |   |         | 2001 | 
|Cash flows from operating activities:                                                              |  |                          |         |   |      |   |         |      |  |   |         |  
|Net income (loss)                                                                                  |  | $                        | 27,323  |   |      | $ | (15,338 | )    |  | $ | (17,814 | )
|Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: |  |                          |         |   |      |   |         |      |  |   |         |  
|Provision for doubtful accounts receivable                                                         |  |                          | 404     |   |      |   | 3       |      |  |   | 20      |  
|Provision for excess and obsolete inventories                                                      |  |                          | 550     |   |      |   | 470     |      |  |   | 95      |  
|Depreciation and amortization                                                                      |  |                          | 2,237   |   |      |   | 1,298   |      |  |   | 865     |  
|Deferred tax assets                                                                                |  |                          | (21,625 | ) |      |   |        |      |  |   |        |  
|Tax benefit from stock options                                                                     |  |                          | 3,496   |   |      |   |        |      |  |   |        |  
|Loss on disposal of property and equipment                                                         |  |                          | 47      |   |      |   | 60      |      |  |   | 122     |  
|Non-cash interest expense                                                                          |  |                          |        |   |      |   | 3,081   |      |  |   |        |  
|Amortization of deferred stock-based compensation                                                  |  |                          | 5,966   |   |      |   | 6,328   |      |  |   | 5,156   |  
|Write-off of in-process research and development                                                   |  |                          | 636     |   |      |   | 12,250  |      |  |   |        |  
|Changes in operating assets and liabilities, net of effect of acquisition:                         |  |                          |         |   |      |   |         |      |  |   |         |  
|Accounts receivable                                                                                |  |                          | (11,086 | ) |      |   | (8,358  | )    |  |   | (3,740  | )
|Inventories                                                                                        |  |                          | (2,373  | ) |      |   | (2,493  | )    |  |   | (1,105  | )
|Prepaid expenses and other current assets                                                          |  |                          | (1,452  | ) |      |   | (1,739  | )    |  |   | (284    | )
|Other assets                                                                                       |  |                          | (1,182  | ) |      |   | 1,100   |      |  |   | (35     | )
|Accounts payable                                                                                   |  |                          | 3,013   |   |      |   | 518     |      |  |   | 1,609   |  
|Accrued liabilities                                                                                |  |                          | 7,031   |   |      |   | 3,757   |      |  |   | 2,123   |  
|                                                                                                   |  |                          |         |   |      |   |         |      |  |   |         |  
|Net cash provided by (used in) operating activities                                                |  |                          | 12,985  |   |      |   | 937     |      |  |   | (12,988 | )
|                                                                                                   |  |                          |         |   |      |   |         |      |  |   |         |  
|                                                                                                   |  |                          |        
|Cash flows from investing activities:                                                              |  |                          |         |   |      |   |         |      |  |   |         |  
|Acquisition of property and equipment                                                              |  |                          | (3,961  | ) |      |   | (2,571  | )    |  |   | (1,629  | )
|Proceeds from disposal of property and equipment                                                   |  |                          |        |   |      |   | 20      |      |  |   |        |  
|Maturities and sales of investments                                                                |  |                          | 30,023  |   |      |   |        |      |  |   |        |  
|Purchases of investments                                                                           |  |                          | (34,537 | ) |      |   | (24,663 | )    |  |   |        |  
|Payment for acquisition                                                                            |  |                          | (4,850  | ) |      |   | (12,250 | )    |  |   |        |  
|                                                                                                   |  |                          |         |   |      |   |         |      |  |   |         |  
|Net cash used in investing activities                                                              |  |                          | (13,325 | ) |      |   | (39,464 | )    |  |   | (1,629  | )
|                                                                                                   |  |                          |         |   |      |   |         |      |  |   |         |  
|                                                                                                   |  |                          |        
|Cash flows from financing activities:                                                              |  |                          |         |   |      |   |         |      |  |   |         |  
|Proceeds from issuance of common stock, net                                                        |  |                          | 1,417   |   |      |   | 94,925  |      |  |   |        |  
|Repurchase of common stock                                                                         |  |                          |        |   |      |   | (23     | )    |  |   | (25     | )
|Proceeds from exercise of warrants                                                                 |  |                          |        |   |      |   | 77      |      |  |   |        |  
|Proceeds from exercise of stock options                                                            |  |                          | 2,640   |   |      |   | 1,254   |      |  |   | 166     |  
|Proceeds from payment of related party note receivable                                             |  |                          | 2,510   |   |      |   | 379     |      |  |   |        |  
|Issuance of related party note receivable                                                          |  |                          |        |   |      |   |        |      |  |   | (2,889  | )
|Acquisition of treasury stock                                                                      |  |                          |        |   |      |   | (201    | )    |  |   |        |  
|Proceeds from convertible promissory notes                                                         |  |                          |        |   |      |   | 2,000   |      |  |   | 12,000  |  
|Repayment of convertible promissory notes                                                          |  |                          |        |   |      |   | (13,300 | )    |  |   |        |  
|Repayment of notes payable                                                                         |  |                          |        |   |      |   | (159    | )    |  |   | (144    | )
|                                                                                                   |  |                          |         |   |      |   |         |      |  |   |         |  
|Net cash provided by financing activities                                                          |  |                          | 6,567   |   |      |   | 84,952  |      |  |   | 9,108   |  
|                                                                                                   |  |                          |         |   |      |   |         |      |  |   |         |  
|Effect of foreign exchange rates on cash                                                           |  |                          | 1,400   |   |      |   | 90      |      |  |   | (37     | )
|Net increase (decrease) in cash and cash equivalents                                               |  |                          | 7,627   |   |      |   | 46,515  |      |  |   | (5,546  | )
|                                                                                                   |  |                          |        
|Cash and cash equivalents at beginning of year                                                     |  |                          | 49,867  |   |      |   | 3,352   |      |  |   | 8,898   |  
|                                                                                                   |  |                          |         |   |      |   |         |      |  |   |         |  
|Cash and cash equivalents at end of year                                                           |  | $                        | 57,494  |   |      | $ | 49,867  |      |  | $ | 3,352   |  
|                                                                                                   |  |                          |         |   |      |   |         |      |  |   |         |  
|                                                                                                   |  |                          |        
|Supplementary disclosure of noncash financing activities:                                          |  |                          |         |   |      |   |         |      |  |   |         |  
|Deferred stock-based compensation                                                                  |  | $                        | 454     |   |      | $ | 2,193   |      |  | $ | 14,457  |  
|                                                                                                   |  |                          |         |   |      |   |         |      |  |   |         |  
|Issuance of warrants                                                                               |  |                          |        |   |      |   | 1,540   |      |  |   |        |  
|                                                                                                   |  |                          |         |   |      |   |         |      |  |   |         |  
|Conversion of redeemable convertible preferred stock to common stock                               |  |                          |        |   |      |   | 38,024  |      |  |   |        |  
|                                                                                                   |  |                          |         |   |      |   |         |      |  |   |         |  
|Supplemental disclosure of cash flow information:                                                  |  |                          |         |   |      |   |         |      |  |   |         |  
|Cash paid during period for interest                                                               |  |                          | 23      |   |      |   | 854     |      |  |   | 29      |  
|                                                                                                   |  |                          |         |   |      |   |         |      |  |   |         |  
|Cash paid during period for income taxes                                                           |  | $                        | 43      |   |      | $ |        |      |  | $ |        |  
|                                                                                                   |  |                          |         |   |      |   |         |      |  |   |         |  



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



45



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KYPHON INC.

CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY (DEFICIT)

(in thousands)



|                                                                                                 |  |              |   |  |        |    |                           |   |         |                |  |   |                                  |   |  |                                             |         |   |                     |   |       |                                    |  |   |         |   |  |   |         |  
|------------------------------------------------------------------------------------------------ |  | ------------ | - |  | ------ | -- | ------------------------- | - | ------- | -------------- |  | - | -------------------------------- | - |  | ------------------------------------------- | ------- | - | ------------------- | - | ----- | ---------------------------------- |  | - | ------- | - |  | - | ------- | -
|                                                                                                 |  |              |   |  |        |    | AdditionalPaid-In Capital |   |         | Treasury Stock |  |   | DeferredStock-Based Compensation |   |  | AccumulatedOtherComprehensive Income (Loss) |         |   | Accumulated Deficit |   |       | TotalStockholders Equity(Deficit) | 
|                                                                                                 |  | Common Stock |   |  |        |    |                           |  
|                                                                                                 |  | Shares       |   |  | Amount |    |                           |   |         |                | 
|Balance at January 1, 2001                                                                       |  | 2,338        |   |  | $      | 2  |                           | $ | 8,524   |                |  | $ |                                 |   |  | $                                           | (6,781  | ) |                     | $ |      |                                    |  | $ | (26,879 | ) |  | $ | (25,134 | )
|Exercise of stock options                                                                        |  | 461          |   |  |        |   |                           |   | 165     |                |  |   |                                 |   |  |                                             |        |   |                     |   |      |                                    |  |   |        |   |  |   | 165     |  
|Repurchase of common stock                                                                       |  | (469         | ) |  |        |   |                           |   | (24     | )              |  |   |                                 |   |  |                                             |        |   |                     |   |      |                                    |  |   |        |   |  |   | (24     | )
|Cumulative translation adjustments                                                               |  |             |   |  |        |   |                           |   |        |                |  |   |                                 |   |  |                                             |        |   |                     |   | (16   | )                                  |  |   |        |   |  |   | (16     | )
|Deferred stock-based compensation, net of cancellations                                          |  |             |   |  |        |   |                           |   | 14,457  |                |  |   |                                 |   |  |                                             | (14,457 | ) |                     |   |      |                                    |  |   |        |   |  |   |        |  
|Amortization of deferred stock-based compensation                                                |  |             |   |  |        |   |                           |   |        |                |  |   |                                 |   |  |                                             | 5,156   |   |                     |   |      |                                    |  |   |        |   |  |   | 5,156   |  
|Net loss                                                                                         |  |             |   |  |        |   |                           |   |        |                |  |   |                                 |   |  |                                             |        |   |                     |   |      |                                    |  |   | (17,814 | ) |  |   | (17,814 | )
|                                                                                                 |  |              |   |  |        |    |                           |   |         |                |  |   |                                  |   |  |                                             |         |   |                     |   |       |                                    |  |   |         |   |  |   |         |  
|Balance at December 31, 2001                                                                     |  | 2,330        |   |  |        | 2  |                           |   | 23,122  |                |  |   |                                 |   |  |                                             | (16,082 | ) |                     |   | (16   | )                                  |  |   | (44,693 | ) |  |   | (37,667 | )
|Exercise of stock options                                                                        |  | 1,742        |   |  |        | 2  |                           |   | 1,252   |                |  |   |                                 |   |  |                                             |        |   |                     |   |      |                                    |  |   |        |   |  |   | 1,254   |  
|Repurchase of common stock                                                                       |  | (30          | ) |  |        |   |                           |   | (23     | )              |  |   |                                 |   |  |                                             |        |   |                     |   |      |                                    |  |   |        |   |  |   | (23     | )
|Issuance of common stock upon filing of initial public offering, net of issuance costs of $1,330 |  | 6,900        |   |  |        | 7  |                           |   | 94,918  |                |  |   |                                 |   |  |                                             |        |   |                     |   |      |                                    |  |   |        |   |  |   | 94,925  |  
|Conversion of redeemable convertible preferred stock into common stock                           |  | 26,291       |   |  |        | 26 |                           |   | 37,998  |                |  |   |                                 |   |  |                                             |        |   |                     |   |      |                                    |  |   |        |   |  |   | 38,024  |  
|Issuance of common stock upon exercise of warrants                                               |  | 78           |   |  |        |   |                           |   | 77      |                |  |   |                                 |   |  |                                             |        |   |                     |   |      |                                    |  |   |        |   |  |   | 77      |  
|Conversion of promissory note                                                                    |  | 49           |   |  |        |   |                           |   | 736     |                |  |   |                                 |   |  |                                             |        |   |                     |   |      |                                    |  |   |        |   |  |   | 736     |  
|Warrants issued in connection with promissory note                                               |  |             |   |  |        |   |                           |   | 1,540   |                |  |   |                                 |   |  |                                             |        |   |                     |   |      |                                    |  |   |        |   |  |   | 1,540   |  
|Beneficial conversion feature associated with promissory notes                                   |  |             |   |  |        |   |                           |   | 1,541   |                |  |   |                                 |   |  |                                             |        |   |                     |   |      |                                    |  |   |        |   |  |   | 1,541   |  
|Acquisition of treasury stock                                                                    |  | (30          | ) |  |        |   |                           |   |        |                |  |   | (201                             | ) |  |                                             |        |   |                     |   |      |                                    |  |   |        |   |  |   | (201    | )
|Cumulative translation adjustments                                                               |  |             |   |  |        |   |                           |   |        |                |  |   |                                 |   |  |                                             |        |   |                     |   | 252   |                                    |  |   |        |   |  |   | 252     |  
|Unrealized gain on available-for-sale investments                                                |  |             |   |  |        |   |                           |   |        |                |  |   |                                 |   |  |                                             |        |   |                     |   | 66    |                                    |  |   |        |   |  |   | 66      |  
|Deferred stock-based compensation, net of cancellations                                          |  |             |   |  |        |   |                           |   | 2,193   |                |  |   |                                 |   |  |                                             | (2,193  | ) |                     |   |      |                                    |  |   |        |   |  |   |        |  
|Amortization of deferred stock-based compensation                                                |  |             |   |  |        |   |                           |   |        |                |  |   |                                 |   |  |                                             | 6,328   |   |                     |   |      |                                    |  |   |        |   |  |   | 6,328   |  
|Net loss                                                                                         |  |             |   |  |        |   |                           |   |        |                |  |   |                                 |   |  |                                             |        |   |                     |   |      |                                    |  |   | (15,338 | ) |  |   | (15,338 | )
|                                                                                                 |  |              |   |  |        |    |                           |   |         |                |  |   |                                  |   |  |                                             |         |   |                     |   |       |                                    |  |   |         |   |  |   |         |  
|Balance at December 31, 2002                                                                     |  | 37,330       |   |  |        | 37 |                           |   | 163,354 |                |  |   | (201                             | ) |  |                                             | (11,947 | ) |                     |   | 302   |                                    |  |   | (60,031 | ) |  |   | 91,514  |  
|Exercise of stock options                                                                        |  | 1,875        |   |  |        | 2  |                           |   | 2,638   |                |  |   |                                 |   |  |                                             |        |   |                     |   |      |                                    |  |   |        |   |  |   | 2,640   |  
|Issuance of common stock under employee stock plans                                              |  | 176          |   |  |        |   |                           |   | 1,417   |                |  |   |                                 |   |  |                                             |        |   |                     |   |      |                                    |  |   |        |   |  |   | 1,417   |  
|Issuance of common stock upon exercise of warrants                                               |  | 59           |   |  |        |   |                           |   |        |                |  |   |                                 |   |  |                                             |        |   |                     |   |      |                                    |  |   |        |   |  |   |        |  
|Tax benefits from exercise of common stock options                                               |  |             |   |  |        |   |                           |   | 3,496   |                |  |   |                                 |   |  |                                             |        |   |                     |   |      |                                    |  |   |        |   |  |   | 3,496   |  
|Cumulative translation adjustments                                                               |  |             |   |  |        |   |                           |   |        |                |  |   |                                 |   |  |                                             |        |   |                     |   | 1,934 |                                    |  |   |        |   |  |   | 1,934   |  
|Changes in unrealized gains (losses) on available-for-sale investments                           |  |             |   |  |        |   |                           |   |        |                |  |   |                                 |   |  |                                             |        |   |                     |   | (40   | )                                  |  |   |        |   |  |   | (40     | )
|Deferred stock-based compensation, net of cancellations                                          |  |             |   |  |        |   |                           |   | 454     |                |  |   |                                 |   |  |                                             | (454    | ) |                     |   |      |                                    |  |   |        |   |  |   |        |  
|Amortization of deferred stock-based compensation                                                |  |             |   |  |        |   |                           |   |        |                |  |   |                                 |   |  |                                             | 5,966   |   |                     |   |      |                                    |  |   |        |   |  |   | 5,966   |  
|Net income                                                                                       |  |             |   |  |        |   |                           |   |        |                |  |   |                                 |   |  |                                             |        |   |                     |   |      |                                    |  |   | 27,323  |   |  |   | 27,323  |  
|                                                                                                 |  |              |   |  |        |    |                           |   |         |                |  |   |                                  |   |  |                                             |         |   |                     |   |       |                                    |  |   |         |   |  |   |         |  
|Balance at December 31, 2003                                                                     |  | 39,440       |   |  | $      | 39 |                           | $ | 171,359 |                |  | $ | (201                             | ) |  | $                                           | (6,435  | ) |                     | $ | 2,196 |                                    |  | $ | (32,708 | ) |  | $ | 134,250 |  
|                                                                                                 |  |              |   |  |        |    |                           |   |         |                |  |   |                                  |   |  |                                             |         |   |                     |   |       |                                    |  |   |         |   |  |   |         |  



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



46



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KYPHON INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



1. ORGANIZATION



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



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s international subsidiaries use the 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 a separate component of stockholders equity (deficit).



Use of Estimates



In accordance with accounting principles generally accepted in the United States of America, management utilizes certain estimates and assumptions that affect the
reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The primary estimates underlying the Companys financial statements include
allowance for doubtful accounts receivable, reserves for obsolete and slow moving inventory, income taxes and accrual for other liabilities. Actual results could differ from those estimates.



Cash and Cash Equivalents



The Company considers all highly liquid investments purchased with original maturities of
three months or less to be cash equivalents. Cash and cash equivalents include money market funds, certificates of deposit, and commercial paper.



Restricted Cash



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



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KYPHON INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



Investments



All investments are classified as available-for-sale and therefore are carried at fair market value. Unrealized gains and losses on such investments are reported as a
separate component of stockholders equity (deficit). Realized gains and losses on sale of all such investments are reported in earnings and computed using the specific identification cost method. The Companys available-for-sale
investments are summarized as follows (in thousands):



|                                               |  |               |        |                      |   |                       |  |   |           |   |  |   |       
|---------------------------------------------- |  | ------------- | ------ | -------------------- | - | --------------------- |  | - | --------- | - |  | - | ------
|December 31, 2003                              |  | AmortizedCost |        | GrossUnrealizedGains |   | GrossUnrealizedLosses |  |   | FairValue
|Certificates of deposit and money market funds |  | $             | 2,355  |                      | $ |                      |  | $ |          |   |  | $ | 2,355 
|Corporate notes and bonds                      |  |               | 27,959 |                      |   | 28                    |  |   | (2        | ) |  |   | 27,985
|                                               |  |               |        |                      |   |                       |  |   |           |   |  |   |       
|Total                                          |  | $             | 30,314 |                      | $ | 28                    |  | $ | (2        | ) |  | $ | 30,340
|                                               |  |               |        |                      |   |                       |  |   |           |   |  |   |       
|Reported as:                                   |  |               |        |                      |   |                       |  |   |           |   |  |   |       
|Cash and cash equivalents                      |  |               |        |                      |   |                       |  |   |           |   |  | $ | 2,355 
|Short-term investments                         |  |               |        |                      |   |                       |  |   |           |   |  |   | 13,456
|Long-term investments                          |  |               |        |                      |   |                       |  |   |           |   |  |   | 14,529
|                                               |  |               |        |                      |   |                       |  |   |           |   |  |   |       
|Total                                          |  |               |        |                      |   |                       |  |   |           |   |  | $ | 30,340
|                                               |  |               |        |                      |   |                       |  |   |           |   |  |   |       
|                                               |  |               |        |                     
|December 31, 2002                              |  | AmortizedCost |        | GrossUnrealizedGains |   | GrossUnrealizedLosses |  |   | FairValue
|Certificates of deposit and money market funds |  | $             | 3,235  |                      | $ |                      |  | $ |          |   |  | $ | 3,235 
|Corporate notes and bonds                      |  |               | 26,619 |                      |   | 68                    |  |   | (2        | ) |  |   | 26,685
|                                               |  |               |        |                      |   |                       |  |   |           |   |  |   |       
|Total                                          |  | $             | 29,854 |                      | $ | 68                    |  | $ | (2        | ) |  | $ | 29,920
|                                               |  |               |        |                      |   |                       |  |   |           |   |  |   |       
|Reported as:                                   |  |               |        |                      |   |                       |  |   |           |   |  |   |       
|Cash and cash equivalents                      |  |               |        |                      |   |                       |  |   |           |   |  | $ | 5,484 
|Short-term investments                         |  |               |        |                      |   |                       |  |   |           |   |  |   | 21,224
|Long-term investments                          |  |               |        |                      |   |                       |  |   |           |   |  |   | 3,212 
|                                               |  |               |        |                      |   |                       |  |   |           |   |  |   |       
|Total                                          |  |               |        |                      |   |                       |  |   |           |   |  | $ | 29,920
|                                               |  |               |        |                      |   |                       |  |   |           |   |  |   |       



The following table summarizes the
maturities of our investments as of December 31, 2003 (in thousands):



|                                                |  |   |       
|----------------------------------------------- |  | - | ------
|Corporate notes and bonds:                      |  |   |       
|Maturities of one year or less                  |  | $ | 13,456
|Maturities between one and two years            |  |   | 14,529
|                                                | 
|Certificates of deposit and money market funds: |  |   |       
|Original maturities of three months or less     |  |   | 2,355 
|                                                |  |   |       
|Total                                           |  | $ | 30,340
|                                                |  |   |       



Allowance for Doubtful Accounts



The Company estimates the allowance for doubtful accounts related to
trade receivables based on an evaluation of the specific accounts where the Company has information that the customer may have an inability to meet its financial obligations. In those cases, the Company uses its judgment, based on the best available
facts and circumstances, and records a specific reserve for that customer against amounts due to reduce the receivable to the amount that is expected to be collected. These specific reserves are reevaluated and adjusted as additional information is
received that impacts the amount reserved.



Inventories



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





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##### Table of Contents

KYPHON INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



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 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.



Goodwill and Other Intangible Assets



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



The Company is amortizing its intangible assets on a straight
line basis over a five year period. No amortization of goodwill has been recorded. Instead, the Company will perform an assessment for impairment by applying a fair-value based test in the first quarter of each year, or more frequently if changes in
circumstances or the occurrence of events suggest the remaining value is not recoverable.



Impairment of Long-Lived Assets



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



Concentrations of Credit Risk and Other Risks and Uncertainties



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



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



The Companys accounts receivable are derived from net sales earned from customers
located in the United States of America and Europe. The Company performs ongoing credit evaluations of its customers financial condition and, generally, requires no collateral from its customers. As of December 31, 2003, 73% and 27%,
respectively, of the accounts receivables were from United States of America and Europe. As of December 31, 2002, 90% and 10%, respectively, of the accounts receivables were from United States of America and Europe.



No customer accounted for more than 10% of total net sales for the years ended December 31,
2003, 2002 and 2001. No customer accounted for more than 10% of total accounts receivable at December 31, 2003, and 2002.





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KYPHON INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



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



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



Revenue Recognition



The Companys revenue is derived from the sale of its products to customers and
distributors. Revenue from product sales, net of discounts, is recognized upon receipt of a valid purchase order, shipment of the products and when collection of the receivables is deemed probable.



Shipping and Handling of Products



Amounts billed to customers for shipping and handling of products are included in net sales
and were approximately $400,000 in 2003. Prior to 2003, such amounts were insignificant and were classified as an offset to cost of goods sold. Costs incurred related to shipping and handling of products are included in cost of goods sold.



Research and Development



Research and development expenses are charged to operations as incurred.



Advertising Costs



Advertising costs, included in sales and marketing expenses, are expensed as incurred. Advertising costs were approximately $3,552,000,
$1,873,000, and $919,000 for the years ended December 31, 2003, 2002 and 2001, respectively.



Income Taxes



The Company accounts for
income taxes under the liability method whereby deferred tax asset or liability account balances are calculated at the balance sheet date using current tax laws and rates in effect for the year in which the differences are expected to affect taxable
income. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be realized.



Segments



The Company operates in one segment, using one measurement of profitability to manage its business. As of December 31, 2003 and 2002, 49% and 91%, respectively, of all long-lived assets were maintained in the United
States of America. As the Company acquired Sanatis GmbH (Sanatis), a German company in February 2003, net goodwill and other intangible assets comprised 43% of long-lived assets. For the years ended December 31, 2003, 2002 and 2001, 90%,
93%, and 98%, respectively, of net sales were generated in the United States of America.



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##### Table of Contents

KYPHON INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



Comprehensive Income (Loss)



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



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



|                                                                       |  |                          |        |   |      |   |         |      |  |   |         |  
|---------------------------------------------------------------------- |  | ------------------------ | ------ | - | ---- | - | ------- | ---- |  | - | ------- | -
|                                                                       |  | Years Ended December 31, |       
|                                                                       |  | 2003                     |        |   | 2002 |   |         | 2001 | 
|Net income (loss)                                                      |  | $                        | 27,323 |   |      | $ | (15,338 | )    |  | $ | (17,814 | )
|Changes in unrealized gains (losses) on available-for-sale investments |  |                          | (40    | ) |      |   | 66      |      |  |   |        |  
|Translation adjustments                                                |  |                          | 1,934  |   |      |   | 252     |      |  |   | (16     | )
|                                                                       |  |                          |        |   |      |   |         |      |  |   |         |  
|                                                                       |  |                          |       
|Total comprehensive income (loss)                                      |  | $                        | 29,217 |   |      | $ | (15,020 | )    |  | $ | (17,830 | )
|                                                                       |  |                          |        |   |      |   |         |      |  |   |         |  



The components of comprehensive income
(loss) reflected in the consolidated statements of stockholders equity (deficit) are as follows:



|                                                            |  |              |       |      |   |    
|----------------------------------------------------------- |  | ------------ | ----- | ---- | - | ---
|                                                            |  | December 31,
|                                                            |  | 2003         |       | 2002
|Unrealized gains (losses) on available-for-sale investments |  | $            | 26    |      | $ | 66 
|Translation adjustments                                     |  |              | 2,170 |      |   | 236
|                                                            |  |              |       |      |   |    
|                                                            |  |             
|                                                            |  | $            | 2,196 |      | $ | 302
|                                                            |  |              |       |      |   |    



Net Income (Loss) per Share



Basic net income (loss) per share is computed by dividing net income
(loss) by the weighted-average number of common shares outstanding for the period. Diluted net income (loss) per share is computed giving effect to all potential dilutive common stock, including options, warrants, common stock subject to repurchase,
convertible promissory notes and redeemable convertible preferred stock. For the years ended December 31, 2002 and 2001, options, common stock subject to a right of repurchase, warrants, convertible promissory notes and redeemable convertible
preferred stock were not included in the computation of diluted net income (loss) per share for the Company because the effect would be antidilutive.



51



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##### Table of Contents

KYPHON INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



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



|                                                    |  |                          |        |   |      |   |         |      |  |   |         |  
|--------------------------------------------------- |  | ------------------------ | ------ | - | ---- | - | ------- | ---- |  | - | ------- | -
|                                                    |  | Years Ended December 31, |       
|                                                    |  | 2003                     |        |   | 2002 |   |         | 2001 | 
|Net income (loss)                                   |  | $                        | 27,323 |   |      | $ | (15,338 | )    |  | $ | (17,814 | )
|                                                    |  |                          |        |   |      |   |         |      |  |   |         |  
|Weighted-average shares outstanding                 |  |                          | 38,461 |   |      |   | 24,514  |      |  |   | 2,259   |  
|Less: weighted-average shares subject to repurchase |  |                          | (28    | ) |      |   | (109    | )    |  |   | (292    | )
|                                                    |  |                          |        |   |      |   |         |      |  |   |         |  
|Basic weighted-average shares outstanding           |  |                          | 38,433 |   |      |   | 24,405  |      |  |   | 1,967   |  
|                                                    |  |                          |        |   |      |   |         |      |  |   |         |  
|Dilutive effect of:                                 |  |                          |        |   |      |   |         |      |  |   |         |  
|Options to purchase common stock                    |  |                          | 3,610  |   |      |   |        |      |  |   |        |  
|Warrants                                            |  |                          | 47     |   |      |   |        |      |  |   |        |  
|                                                    |  |                          |        |   |      |   |         |      |  |   |         |  
|Diluted weighted-average shares outstanding         |  |                          | 42,090 |   |      |   | 24,405  |      |  |   | 1,967   |  
|                                                    |  |                          |        |   |      |   |         |      |  |   |         |  
|Net income (loss) per share:                        |  |                          |        |   |      |   |         |      |  |   |         |  
|Basic                                               |  | $                        | 0.71   |   |      | $ | (0.63   | )    |  | $ | (9.06   | )
|Diluted                                             |  | $                        | 0.65   |   |      | $ | (0.63   | )    |  | $ | (9.06   | )



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



|                                       |  |              |  |       |  |       
|-------------------------------------- |  | ------------ |  | ----- |  | ------
|                                       |  | December 31,
|                                       |  | 2003         |  | 2002  |  | 2001  
|Options to purchase common stock       |  | 146          |  | 6,826 |  | 7,326 
|Common stock subject to repurchase     |  | 13           |  | 34    |  | 113   
|Redeemable convertible preferred stock |  |             |  |      |  | 26,291
|Warrants                               |  |             |  | 64    |  | 43    



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. As of December 31, 2003, the Company held 30,000 shares of treasury stock. Treasury stock is accounted for by the cost method.



Accounting for Stock-Based Compensation



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



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KYPHON INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



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



|                                                                                                                             |  |                          |        |   |      |   |         |      |  |   |         |  
|---------------------------------------------------------------------------------------------------------------------------- |  | ------------------------ | ------ | - | ---- | - | ------- | ---- |  | - | ------- | -
|                                                                                                                             |  | Years Ended December 31, |       
|                                                                                                                             |  | 2003                     |        |   | 2002 |   |         | 2001 | 
|Net income (loss), as reported                                                                                               |  | $                        | 27,323 |   |      | $ | (15,338 | )    |  | $ | (17,814 | )
|Add: Stock-based employee compensation expense included in reported net income (loss), net of tax                            |  |                          | 2,447  |   |      |   | 5,183   |      |  |   | 2,988   |  
|Deduct: Total stock-based employee compensation expense, determined under fair value based method for all awards, net of tax |  |                          | (5,870 | ) |      |   | (6,313  | )    |  |   | (3,189  | )
|                                                                                                                             |  |                          |        |   |      |   |         |      |  |   |         |  
|                                                                                                                             |  |                          |       
|Pro forma net income (loss)                                                                                                  |  | $                        | 23,900 |   |      | $ | (16,468 | )    |  | $ | (18,015 | )
|                                                                                                                             |  |                          |        |   |      |   |         |      |  |   |         |  
|Net income (loss) per share                                                                                                  |  |                          |        |   |      |   |         |      |  |   |         |  
|Basic:                                                                                                                       |  |                          |        |   |      |   |         |      |  |   |         |  
|As reported                                                                                                                  |  | $                        | 0.71   |   |      | $ | (0.63   | )    |  | $ | (9.06   | )
|Pro forma                                                                                                                    |  | $                        | 0.62   |   |      | $ | (0.67   | )    |  | $ | (9.16   | )
|                                                                                                                             |  |                          |       
|Diluted:                                                                                                                     |  |                          |        |   |      |   |         |      |  |   |         |  
|As reported                                                                                                                  |  | $                        | 0.65   |   |      | $ | (0.63   | )    |  | $ | (9.06   | )
|Pro forma                                                                                                                    |  | $                        | 0.57   |   |      | $ | (0.67   | )    |  | $ | (9.16   | )



The weighted-average assumptions used
are as follows:



|                         |  |                          |   |  |                                  |   |  |      |   |  |      |  
|------------------------ |  | ------------------------ | - |  | -------------------------------- | - |  | ---- | - |  | ---- | -
|                         |  | Years Ended December 31, |  
|                         |  | Employee Stock Options   |   |  | Employee StockPurchase Plan 2003 |  
|                         |  | 2003                     |   |  | 2002                             |   |  | 2001 |   | 
|                         |  |                          |   |  |                                  |   |  |      |   |  |      |  
|Risk-free interest rate  |  | 2.58                     | % |  | 3.59                             | % |  | 4.87 | % |  | 1.15 | %
|Expected volatility      |  | 70                       | % |  | 76                               | % |  |     |   |  | 66   | %
|Expected life (in years) |  | 4                        |   |  | 4                                |   |  | 4    |   |  | 0.74 |  
|Dividend yield           |  |                         |   |  |                                 |   |  |     |   |  |     |  



The weighted-average grant date fair
value per share of options granted during the years ended December 31, 2003, 2002 and 2001 was $8.84, $4.89, and $0.82, respectively. The weighted average fair value for shares purchased through the employee stock purchase plans during the year
ended December 31, 2003 was $3.96 per share.



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



Deferred 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 contain 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 lapses as these shares became vested to the employee. In accordance with the requirements of APB No. 25, the Company has recorded deferred stock-based compensation for the difference between the exercise
price of the stock options or restricted common stock and the deemed fair market value of the Companys stock at the date of grant. This deferred stock-based compensation is amortized to expense on a straight line basis, over the period during
which the Companys right to repurchase the restricted common stock lapses or the options become exercisable, generally four years.



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KYPHON INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



Stock-based compensation expense related to stock options granted to non-employees is recognized as the stock options
are earned. The options generally vest ratably over four years. The values attributable to these options have been amortized over the service period on a graded vesting method, and the vested portion of these options were remeasured at each vesting
date. The Company believes that the fair value of the stock options is more reliably measurable than the fair value of the services received. The fair value of the stock options granted were revalued at each reporting date using the Black-Scholes
option pricing model as prescribed by SFAS No. 123 using the following weighted-average assumptions:



|                         |  |                          |   |  |      |   |  |      |  
|------------------------ |  | ------------------------ | - |  | ---- | - |  | ---- | -
|                         |  | Years Ended December 31, |  
|                         |  | 2003                     |   |  | 2002 |   |  | 2001 |  
|Risk-free interest rate  |  | 3.92                     | % |  | 4.45 | % |  | 4.99 | %
|Expected volatility      |  | 74                       | % |  | 76   | % |  | 76   | %
|Expected life (in years) |  | 10                       |   |  | 10   |   |  | 10   |  
|Dividend yield           |  |                         |   |  |     |   |  |     |  



As of December 31, 2003, the Company
has recorded a cumulative $25,269,000 of deferred stock-based compensation related to stock options granted to non-employees and employees. Stock-based compensation expense is being recognized on a straight-line basis over the vesting periods of the
related options, generally four years. The Company recognized stock-based compensation expense as follows (in thousands):



|                           |  |                          |       |      |   |       |  |   |      
|-------------------------- |  | ------------------------ | ----- | ---- | - | ----- |  | - | -----
|                           |  | Years Ended December 31,
|                           |  | 2003                     |       | 2002 |   | 2001 
|Cost of goods sold         |  | $                        | 467   |      | $ | 587   |  | $ | 472  
|Research and development   |  |                          | 2,232 |      |   | 1,906 |  |   | 1,074
|Sales and marketing        |  |                          | 2,012 |      |   | 2,243 |  |   | 1,108
|General and administrative |  |                          | 1,255 |      |   | 1,592 |  |   | 2,502
|                           |  |                          |       |      |   |       |  |   |      
|                           |  | $                        | 5,966 |      | $ | 6,328 |  | $ | 5,156
|                           |  |                          |       |      |   |       |  |   |      



Reclassification



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



Recent Accounting Pronouncements



In April 2002, the FASB issued SFAS No. 145 (SFAS No. 145), Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and
Technical Corrections, which is effective for fiscal years beginning after May 15, 2002. Under SFAS No. 145, gains and losses from the extinguishment of debt should be classified as extraordinary items only if they meet the criteria of
Accounting Principles Board Opinion No. 30, Reporting the Results of Operations  Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions Relating to
Extraordinary Items. SFAS No. 145 also addresses financial accounting and reporting for capital leases that are modified in such a way as to give rise to a new agreement classified as an operating lease. The adoption of SFAS No. 145 did not
have a material impact on the consolidated financial position or results of the operations of the Company.



In June 2002, the FASB issued SFAS No. 146 (SFAS No. 146), Accounting for Costs Associated with Exit or Disposal Activities, which is effective for exit or disposal activities initiated after
December 31, 2002. SFAS No. 146 nullifies EITF No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring). Under SFAS No. 146, a
liability is required to be recognized for a cost associated with an exit or disposal activity when the liability is incurred. SFAS No. 146 applies to costs associated with an exit activity that does not involve an entity newly acquired in a
business combination or with a retirement or disposal activity covered



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##### Table of Contents

KYPHON INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



by FASB Statements No. 143, Accounting for Asset Retirement Obligations, and No. 144, Accounting
for the Impairment or Disposal of Long-Lived Assets. The adoption of SFAS No. 146 did not have a material impact on the consolidated financial position or results of the operations of the Company.



In November 2002, the EITF reached a consensus on EITF Issue No. 00-21, Accounting for
Revenue Arrangements with Multiple Deliverables (EITF Issue No. 00-21). EITF Issue No. 00-21 provides guidance on how to account for arrangements that involve the delivery or performance of multiple products, services and/or rights
to use assets. The provisions of EITF Issue No. 00-21 applied to revenue arrangements entered into in fiscal periods beginning after June 15, 2003, including quarters. The adoption of EITF Issue No. 00-21 did not have a material impact on the
consolidated financial position or its results of the operations of the Company.



In December 2003, the FASB issued a revised FASB Interpretation No. 46 (FIN 46R), Consolidation of Variable Interest Entities, an interpretation of ARB No. 51. The FASB published the revision to clarify and amend
some of the original provisions of FIN 46, which was issued in January 2003, and to exempt certain entities from its requirements. A variable interest entity (VIE) refers to an entity subject to consolidation according to the provisions
of this Interpretation. FIN 46R applies to entities whose equity investment at risk is insufficient to finance that entitys activities without receiving additional subordinated financial support provided by any parties, including equity
holders, or where the equity investors (if any) do not have a controlling financial interest. FIN 46R provides that if an entity is the primary beneficiary of a VIE, the assets, liabilities, and results of operations of the VIE should be
consolidated in the entitys financial statements. In addition, FIN 46R requires that both the primary beneficiary and all other enterprises with a significant variable interest in a VIE provide additional disclosures. The provisions of FIN 46R
are effective for the Companys fiscal 2004 first quarter. The Company does not expect the adoption of FIN 46R to have a material impact on the Companys financial position or results of operations.



In May 2003, the FASB issued SFAS No. 150 (SFAS No. 150), Accounting for
Certain Financial Instruments with Characteristics of both Liabilities and Equity, which establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. SFAS
No. 150 requires that an issuer classify a financial instrument that is within its scope as a liability, or an asset in some circumstances. SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003, and
otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. SFAS No. 150 is to be implemented by reporting the cumulative effect of a change in an accounting principle for financial instruments created before
the issuance date of SFAS No. 150 and still existing at the beginning of the interim period of adoption. Restatement is not permitted. The adoption of SFAS No. 150 did not have a material impact on the consolidated financial position or its results
of the operations of the Company.



3. BALANCE SHEET COMPONENTS



Inventories(in thousands):



|                |  |              |       |      |   |      
|--------------- |  | ------------ | ----- | ---- | - | -----
|                |  | December 31,
|                |  | 2003         |       | 2002
|Raw materials   |  | $            | 3,327 |      | $ | 2,039
|Work-in-process |  |              | 647   |      |   | 767  
|Finished goods  |  |              | 2,265 |      |   | 1,610
|                |  |              |       |      |   |      
|                |  | $            | 6,239 |      | $ | 4,416
|                |  |              |       |      |   |      



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KYPHON INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



Property and Equipment (in thousands):



|                                                |  |              |        |   |      |   |        |  
|----------------------------------------------- |  | ------------ | ------ | - | ---- | - | ------ | -
|                                                |  | December 31, |       
|                                                |  | 2003         |        |   | 2002 |  
|Furniture and fixtures                          |  | $            | 1,284  |   |      | $ | 1,054  |  
|Computer software and hardware                  |  |              | 3,455  |   |      |   | 2,615  |  
|Laboratory and manufacturing equipment          |  |              | 3,585  |   |      |   | 2,080  |  
|Leasehold improvements                          |  |              | 965    |   |      |   | 811    |  
|                                                |  |              |        |   |      |   |        |  
|                                                |  |              | 9,289  |   |      |   | 6,560  |  
|Less: Accumulated depreciation and amortization |  |              | (4,474 | ) |      |   | (2,841 | )
|Plus: Construction-in-progress                  |  |              | 1,229  |   |      |   | 546    |  
|                                                |  |              |        |   |      |   |        |  
|                                                |  | $            | 6,044  |   |      | $ | 4,265  |  
|                                                |  |              |        |   |      |   |        |  



Goodwill and Intangible Assets:



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



|                                                |  |   |       |  
|----------------------------------------------- |  | - | ----- | -
|Goodwill acquired during the year               |  | $ | 4,072 |  
|Foreign currency translation                    |  |   | 512   |  
|                                                |  |   |       |  
|Goodwill at December 31, 2003                   |  |   | 4,584 |  
|                                                |  |   |       |  
|Patents acquired during the year                |  |   | 142   |  
|Foreign currency translation                    |  |   | 22    |  
|Accumulated amortization                        |  |   | (26   | )
|                                                |  |   |       |  
|Patents at December 31, 2003                    |  |   | 138   |  
|                                                |  |   |       |  
|                                                | 
|Total goodwill and other intangible assets, net |  | $ | 4,722 |  
|                                                |  |   |       |  



Amortization expense for the
Companys intangible assets was approximately $25,800 for the year ended December 31, 2003. Based on the intangible assets held at December 31, 2003, the Company expects to recognize amortization expense of approximately $28,400 in each of the
years from 2004 to 2007, and approximately $4,000 in 2008.



Accrued
Liabilities(in thousands):



|                                        |  |              |        |      |   |      
|--------------------------------------- |  | ------------ | ------ | ---- | - | -----
|                                        |  | December 31,
|                                        |  | 2003         |        | 2002
|Payroll and related expenses            |  | $            | 7,366  |      | $ | 4,817
|Legal, accounting and professional fees |  |              | 1,122  |      |   | 812  
|Professional training course            |  |              | 227    |      |   | 299  
|Travel and entertainment                |  |              | 621    |      |   | 402  
|Deferred rent                           |  |              | 24     |      |   | 176  
|Accrued income taxes                    |  |              | 4,108  |      |   |     
|Other                                   |  |              | 1,231  |      |   | 986  
|                                        |  |              |        |      |   |      
|                                        |  | $            | 14,699 |      | $ | 7,492
|                                        |  |              |        |      |   |      



4. NOTES PAYABLE



In 1997 and 1998, the Company entered into two equipment financing lines totaling $650,000.
Prior to the lines expirations, the Company had drawn down $541,800, which was collateralized by the related equipment. Both of these lines were repaid entirely in June 2002. The Company issued warrants to



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KYPHON INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



purchase an aggregate of 18,358 shares of convertible preferred stock to the lenders in connection with these lines
at a weighted-average exercise price of $0.62 per share. To effect a cashless exercise of the warrants, 17,601 shares of common stock were issued subsequent to the Companys initial public offering. All warrants related to the equipment
financing lines were exercised in 2002.



5. CONVERTIBLE PROMISSORY NOTES



Between July 2001 and February 2002, the Company raised $13,300,000
through the sale of convertible promissory notes with several affiliates pursuant to a loan agreement. The convertible promissory notes bore interest at 10% rate per annum. The outstanding principal and accrued interest were repaid upon the closing
of the Companys initial public offering. In addition, in November 2001, the Company raised $700,000 through the sale of a convertible promissory note to one affiliate pursuant to the same loan agreement. The principal and accrued interest due
on this note automatically converted into 49,090 shares of the Companys common stock at the initial public offering price of $15.00 per share. As required by the terms of the loan agreement, upon the closing date of the Companys initial
public offering, the Company issued warrants exercisable for an aggregate of 99,334 shares of the Companys common stock at an exercise price of $0.01 per share to the holders of the convertible promissory notes. As of December 31, 2003,
warrants for an aggregate of 4,912 shares of the Companys common stock remained outstanding and exercisable.



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



6. ACQUISITION



In February 2003, the Company purchased all of the outstanding stock of Sanatis, a privately-held developer and manufacturer of orthopedic biomaterials based in Rosbach,
Germany. The acquisition was made to add Sanatis experience developing and manufacturing orthopedic biomaterials and to complement the Companys existing patent portfolio with Sanatis intellectual property surrounding calcium-based
biomaterials and delivery technologies. The total purchase consideration for Sanatis consisted of $4,492,000 in cash, and other acquisition costs of $201,000. In December 2003, the Company paid an additional $157,000 to settle a contract Sanatis had
with a third party prior to its acquisition. In accordance with SFAS 141, Business Combinations, this amount was included in the allocation of the purchase price to goodwill.



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KYPHON INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



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



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



|                                     |  |                          |         |      |   |         |      |  |   |         |  
|------------------------------------ |  | ------------------------ | ------- | ---- | - | ------- | ---- |  | - | ------- | -
|                                     |  | Years Ended December 31, |        
|                                     |  | 2003                     |         | 2002 |   |         | 2001 | 
|                                     |  | (unaudited)              |        
|Net sales                            |  | $                        | 131,028 |      | $ | 76,492  |      |  | $ | 36,232  |  
|Net income (loss)                    |  | $                        | 27,286  |      | $ | (15,393 | )    |  | $ | (17,801 | )
|                                     |  |                          |        
|Net income (loss) per share:         |  |                          |         |      |   |         |      |  |   |         |  
|Basic                                |  | $                        | 0.71    |      | $ | (0.63   | )    |  | $ | (9.05   | )
|                                     |  |                          |         |      |   |         |      |  |   |         |  
|Diluted                              |  | $                        | 0.65    |      | $ | (0.63   | )    |  | $ | (9.05   | )
|                                     |  |                          |         |      |   |         |      |  |   |         |  
|Weighted-average shares outstanding: |  |                          |         |      |   |         |      |  |   |         |  
|Basic                                |  |                          | 38,433  |      |   | 24,405  |      |  |   | 1,967   |  
|                                     |  |                          |         |      |   |         |      |  |   |         |  
|Diluted                              |  |                          | 42,090  |      |   | 24,405  |      |  |   | 1,967   |  
|                                     |  |                          |         |      |   |         |      |  |   |         |  





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KYPHON INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



7. COMMITMENTS AND CONTINGENCIES



Operating leases



In September 2003, the Company entered into a facility lease agreement for a larger corporate headquarters also in Sunnyvale, California, including manufacturing space,
to replace its existing facilities. The agreement is for a ten-year period with the lease obligation period beginning March 1, 2004. Under the terms of the lease agreement, the Company has the option to lease an adjacent existing facility as well as
an option to have additional square footage built and leased to the Company in the same surrounding campus.



In addition, the Company entered into a nine-year lease agreement ending in December 2011 for its European headquarters in Brussels, Belgium.



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



|                                 |  |   |       
|-------------------------------- |  | - | ------
|Fiscal years ending December 31, |  |   |       
|2004                             |  | $ | 1,968 
|2005                             |  |   | 1,711 
|2006                             |  |   | 1,760 
|2007                             |  |   | 1,815 
|2008                             |  |   | 1,862 
|Thereafter                       |  |   | 11,155
|                                 |  |   |       
|Total                            |  | $ | 20,271
|                                 |  |   |       



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, 2003. These future payments are subject to foreign currency exchange rate
risk.



In December 2003, the Company entered into a lease termination agreement
to terminate the existing facility lease in May 2004 which was due to expire in March 2005. In accordance with the provision of SFAS No. 146 Accounting for Costs Associated with Exit or Disposal Activities, which requires recognition of
costs associated with exit or disposal activities when they are incurred rather than at the date of a commitment to an exit or disposal plan, the lease termination charge of $1,200,000 was recorded in December 2003 as a general and administrative
expense. In addition, the amortization of the remaining leasehold improvements in the current facility is being accelerated to be fully amortized by March 31, 2004.



Indemnification Agreements



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



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KYPHON INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



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 determination whether or not it is practicable for the Company to obtain directors and officers insurance. The Company currently has
directors and officers insurance.



Litigation



From time to time, the Company may become involved in litigation relating to additional
claims arising from the ordinary course of business. Management is not currently aware of any litigation matters that may have a material adverse effect on the financial position, results of operations or cash flows of the Company.



8. INITIAL PUBLIC OFFERING



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



9. REDEEMABLE CONVERTIBLE PREFERRED STOCK



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



10. STOCKHOLDERS EQUITY (DEFICIT)



Preferred Stock



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



Common Stock



Each share of common stock is entitled to one vote. The holders of common stock are also entitled to receive dividends whenever funds are legally available and when
declared by the Board of Directors, subject to the prior rights of holders of all classes of stock outstanding. No dividends have been declared or paid as of December 31, 2003.



The Company issued shares of its common stock to certain employees under stock purchase agreements, some of which contain repurchase
provisions in the event of termination of employment. The shares are generally released from repurchase provisions ratably over four years. Included in common stock as of December 31, 2003 and December 31, 2002 are 12,501 and 34,371 shares subject
to the Companys right of repurchase, respectively.



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KYPHON INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



Employee Stock Purchase Plan



In April 2002, the Board of Directors adopted the 2002 Employee Stock Purchase Plan (2002 ESPP), under which eligible employees
are permitted to purchase common stock at a discount through payroll deductions. 750,000 shares of common stock were reserved for issuance and will be increased on the first day of each fiscal year, commencing in 2003, by an amount equal to the
lesser of (i) 1,500,000, (ii) 2.0% of the outstanding shares of common stock on such date or (iii) an amount as determined by the Board of Directors. The Company reserved an additional 747,000 shares of common stock for issuance in 2003. The 2002
ESPP contains consecutive, overlapping twenty-four-month offering periods. Each offering period includes four six-month purchase periods. The price of the common stock purchased shall be the lower of 85% of the fair market value of the common stock
at the beginning of an offering period or at the end of a purchase period. The initial offering period commenced on May 17, 2002, the effective date of the Companys initial public offering. The Company issued approximately 176,000 shares of
common stock in fiscal 2003 under the ESPP. At December 31, 2003, approximately 1,322,000 shares remained available for future issuance.



Director Option Plan



In April 2002, the Board of Directors adopted the 2002 Director Option Plan. The 2002 Director Option Plan, which will terminate no later than 2012, provides for the granting of nonstatutory stock options to
non-employee directors. 200,000 shares of common stock were reserved for issuance and will be increased on the first day of each fiscal year, commencing in 2003, by an amount equal to the lesser of (i) the number of shares subject to options granted
under the 2002 Director Option Plan in the prior fiscal year or (ii) an amount as determined by the Board of Directors. No options were issued and no additional shares were reserved under the Director Option Plan in 2003.



Stock Plan



In April 2002, the Board of Directors adopted the 2002 Stock Plan. The 2002 Stock Plan, which will terminate no later than 2012, provides
for the granting of incentive stock options to employees and nonstatutory stock options to employees, directors and consultants. 2,500,000 shares of common stock were reserved for issuance and will be increased on the first day of each fiscal year,
commencing in 2003, by an amount equal to the lesser of (i) 3,500,000, (ii) 5.0% of the outstanding shares of common stock on the last day of the preceding fiscal year or (iii) an amount as determined by the Board of Directors.



The Company has reserved shares of common stock for issuance under the 1996 Stock Incentive
Plan (the 1996 Plan). Under the 1996 Plan, the Board of Directors may issue incentive stock options to employees and nonstatutory stock options to consultants or employees of the Company.



For the 2002 Director Option Plan, 2002 Stock Plan and 1996 Plan (the Plans), 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
estimated fair market value for nonqualified stock options). If an employee owns stock representing more than 10% of the outstanding shares, the price of each share 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.



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KYPHON INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



Activities under the Plans are as follows:



|                            |  |                          |   |  |                     |   |               |                              |       |                 |          |   |                              |   |      
|--------------------------- |  | ------------------------ | - |  | ------------------- | - | ------------- | ---------------------------- | ----- | --------------- | -------- | - | ---------------------------- | - | -----
|                            |  |                          |   |  | Options Outstanding
|                            |  |                          |   |  | Employees           |   | Non-Employees
|                            |  | SharesAvailablefor Grant |   |  | Number ofShares     |   |               | WeightedAverageExercisePrice |       | Numberof Shares |          |   | WeightedAverageExercisePrice
|Balances, January 1, 2001   |  | 1,237,374                |   |  | 4,426,983           |   |               | $                            | 0.65  |                 | 587,667  |   |                              | $ | 0.74 
|Additional shares reserved  |  | 2,500,000                |   |  |                    |   |               |                              |      |                 |         |   |                              |   |     
|Options granted             |  | (3,630,033               | ) |  | 3,206,783           |   |               |                              | 1.00  |                 | 423,250  |   |                              |   | 1.00 
|Options exercised           |  |                         |   |  | (418,373            | ) |               |                              | 0.36  |                 | (42,083  | ) |                              |   | 0.39 
|Options cancelled           |  | 858,009                  |   |  | (838,009            | ) |               |                              | 0.75  |                 | (20,000  | ) |                              |   | 1.00 
|                            |  |                          |   |  |                     |   |               |                              |       |                 |          |   |                              |   |      
|Balances, December 31, 2001 |  | 965,350                  |   |  | 6,377,384           |   |               |                              | 0.83  |                 | 948,834  |   |                              |   | 0.87 
|Additional shares reserved  |  | 2,500,000                |   |  |                    |   |               |                              |      |                 |         |   |                              |   |     
|Shares repurchased          |  | 30,207                   |   |  |                    |   |               |                              |      |                 |         |   |                              |   |     
|Options granted             |  | (2,223,000               | ) |  | 2,151,500           |   |               |                              | 9.17  |                 | 71,500   |   |                              |   | 2.77 
|Options exercised           |  |                         |   |  | (1,416,022          | ) |               |                              | 0.71  |                 | (326,270 | ) |                              |   | 0.77 
|Options cancelled           |  | 980,981                  |   |  | (980,981            | ) |               |                              | 1.04  |                 |         |   |                              |   |     
|                            |  |                          |   |  |                     |   |               |                              |       |                 |          |   |                              |   |      
|Balances, December 31, 2002 |  | 2,253,538                |   |  | 6,131,881           |   |               |                              | 3.79  |                 | 694,064  |   |                              |   | 1.04 
|Additional shares reserved  |  | 1,867,817                |   |  |                    |   |               |                              |      |                 |         |   |                              |   |     
|Options granted             |  | (2,150,500               | ) |  | 2,113,500           |   |               |                              | 15.68 |                 | 37,000   |   |                              |   | 9.92 
|Options exercised           |  |                         |   |  | (1,453,406          | ) |               |                              | 17.03 |                 | (421,459 | ) |                              |   | 15.16
|Options cancelled           |  | 494,842                  |   |  | (489,842            | ) |               |                              | 4.56  |                 | (5,000   | ) |                              |   | 3.00 
|                            |  |                          |   |  |                     |   |               |                              |       |                 |          |   |                              |   |      
|Balances, December 31, 2003 |  | 2,465,697                |   |  | 6,302,133           |   |               | $                            | 8.25  |                 | 304,605  |   |                              | $ | 1.91 
|                            |  |                          |   |  |                     |   |               |                              |       |                 |          |   |                              |   |      



The options outstanding and
exercisable at December 31, 2003 are as follows:



|                         |  |                     |  |                                                  |  |                                 |       |                    |           |                               |   |      
|------------------------ |  | ------------------- |  | ------------------------------------------------ |  | ------------------------------- | ----- | ------------------ | --------- | ----------------------------- | - | -----
|Options Outstanding      |  | Options Exercisable
|Range of Exercise Prices |  | NumberOutstanding   |  | WeightedAverageRemainingContractualLife in Years |  | Weighted Average Exercise Price |       | OptionsExercisable |           | WeightedAverageExercise Price
|$0.05                    |  | 104,167             |  | 4.79                                             |  | $                               | 0.05  |                    | 104,167   |                               | $ | 0.05 
|0.13                     |  | 105,459             |  | 5.82                                             |  |                                 | 0.13  |                    | 105,459   |                               |   | 0.13 
|0.31                     |  | 135,983             |  | 6.11                                             |  |                                 | 0.31  |                    | 128,623   |                               |   | 0.31 
|0.77                     |  | 301,211             |  | 6.22                                             |  |                                 | 0.77  |                    | 261,444   |                               |   | 0.77 
|1.00                     |  | 2,082,645           |  | 7.22                                             |  |                                 | 1.00  |                    | 1,183,297 |                               |   | 1.00 
|3.00                     |  | 332,671             |  | 8.18                                             |  |                                 | 3.00  |                    | 119,617   |                               |   | 3.00 
|6.95 - 9.98              |  | 993,094             |  | 9.03                                             |  |                                 | 8.52  |                    | 93,205    |                               |   | 7.75 
|10.50 - 12.67            |  | 1,192,385           |  | 8.67                                             |  |                                 | 12.44 |                    | 362,247   |                               |   | 12.46
|15.40 - 25.56            |  | 1,293,623           |  | 9.67                                             |  |                                 | 18.62 |                    | 52,411    |                               |   | 15.59
|$25.84 - 29.04           |  | 65,500              |  | 9.88                                             |  |                                 | 27.91 |                    |          |                               |   |     
|                         |  |                     |  |                                                  |  |                                 |       |                    |           |                               |   |      
|                         |  | 6,606,738           |  | 8.18                                             |  | $                               | 7.96  |                    | 2,410,470 |                               | $ | 3.26 
|                         |  |                     |  |                                                  |  |                                 |       |                    |           |                               |   |      
|Employees                |  | 6,302,133           |  | 8.22                                             |  | $                               | 8.25  |                    | 2,149,617 |                               | $ | 3.47 
|Non-employees            |  | 304,605             |  | 7.31                                             |  |                                 | 1.91  |                    | 260,853   |                               |   | 1.48 
|                         |  |                     |  |                                                  |  |                                 |       |                    |           |                               |   |      
|                         |  | 6,606,738           |  | 8.18                                             |  | $                               | 7.96  |                    | 2,410,470 |                               | $ | 3.26 
|                         |  |                     |  |                                                  |  |                                 |       |                    |           |                               |   |      



At December 31, 2002, 1,708,978
options outstanding granted to employees and 553,624 options outstanding granted to non-employees were exercisable.





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##### Table of Contents

KYPHON INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



11. EMPLOYEE BENEFIT PLAN



The Company maintains a Section 401(k) Plan. The 401(k) Plan provides participating employees with an opportunity to accumulate funds for
retirement and hardship. Eligible participants may contribute up to 20% of their eligible earnings to the Plan Trust. The Company started matching employees contributions to the plan on March 15, 2003 at 25% of employees individual
401(k) contributions up to a maximum of $2,000 per calendar year. The Companys matching contributions totaled $372,000 in fiscal 2003.



12. PURCHASED IN-PROCESS RESEARCH AND DEVELOPMENT



In August 2002, the Company entered into a patent sublicense agreement with Bonutti Research Inc. for the rights to a series of patents, now numbering 25 as of December
31, 2003, issued to Dr. Peter Bonutti. Under the terms of the agreement, the Company acquired the exclusive right to develop minimally-invasive balloons and related products for use within joints, ligaments, tendons, or cartilage in the spine and
the co-exclusive right to develop minimally-invasive balloons and related products for use in orthopedic applications in joints, ligaments, cartilage, nerves or tendons outside of the spine. The Company paid $12,250,000 in cash for the rights, all
of which was immediately expensed to purchased in-process research and development in August 2002. The acquisition cost was immediately expensed to operations as the technology acquired will be used to develop products that have not been approved
for sale by regulatory authorities, and the in-process projects to which the patents may apply had not yet reached technological feasibility and had no alternative future uses. In addition, the Company also entered into a two year consulting
agreement with Dr. Peter Bonutti under which the Company paid $250,000. The prepayment has been capitalized and is being recognized as research and development expense ratably throughout the two year consulting period.



13. RELATED PARTY TRANSACTIONS



In August 1996, the Company entered into two consulting agreements with consultants who are
stockholders of the Company, one of whom was formerly a member of the Board of Directors. Amounts paid for services for the years ended December 31, 2003, 2002 and 2001 were $216,000, $217,000, and $216,000, respectively.



In October 2001, the Company entered into an agreement to loan $2,889,000 to its former
President and Chief Executive Officer, Gary Grenter, for the purchase of a primary residence. The note was non-interest bearing and was collateralized by a deed of trust in the related primary residence. As of December 31, 2003, all outstanding
balances have been paid. As of December 31, 2002, the then outstanding balance of $2,390,000, net of discount, related to the above note receivable was classified with the prepaid expenses and other current assets.



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KYPHON INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



14. INCOME TAXES



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



|                                        |  |                          |         |   |      |   |         |      |  |   |         |  
|--------------------------------------- |  | ------------------------ | ------- | - | ---- | - | ------- | ---- |  | - | ------- | -
|                                        |  | Years Ended December 31, |        
|                                        |  | 2003                     |         |   | 2002 |   |         | 2001 | 
|U.S.                                    |  | $                        | 14,636  |   |      | $ | (15,316 | )    |  | $ | (15,947 | )
|International                           |  |                          | (1,313  | ) |      |   | (22     | )    |  |   | (1,867  | )
|                                        |  |                          |         |   |      |   |         |      |  |   |         |  
|Total income (loss) before income taxes |  | $                        | 13,323  |   |      | $ | (15,338 | )    |  | $ | (17,814 | )
|                                        |  |                          |         |   |      |   |         |      |  |   |         |  
|Current                                 |  |                          |         |   |      |   |         |      |  |   |         |  
|Federal                                 |  | $                        | 4,152   |   |      | $ |        |      |  | $ |        |  
|State                                   |  |                          | 907     |   |      |   |        |      |  |   |        |  
|Foreign                                 |  |                          | 500     |   |      |   |        |      |  |   |        |  
|                                        |  |                          |         |   |      |   |         |      |  |   |         |  
|Total current                           |  |                          | 5,559   |   |      |   |        |      |  |   |        |  
|                                        |  |                          |        
|Deferred                                |  |                          |         |   |      |   |         |      |  |   |         |  
|Federal                                 |  |                          | (15,803 | ) |      |   |        |      |  |   |        |  
|State                                   |  |                          | (3,336  | ) |      |   |        |      |  |   |        |  
|Foreign                                 |  |                          | (420    | ) |      |   |        |      |  |   |        |  
|                                        |  |                          |         |   |      |   |         |      |  |   |         |  
|Total deferred                          |  |                          | (19,559 | ) |      |   |        |      |  |   |        |  
|                                        |  |                          |         |   |      |   |         |      |  |   |         |  
|Total benefit for income tax            |  | $                        | (14,000 | ) |      | $ |        |      |  | $ |        |  
|                                        |  |                          |         |   |      |   |         |      |  |   |         |  



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



At December 31, 2003,
we had approximately $34,600,000 and $28,900,000 in federal and state net operating loss carryforwards, respectively, to reduce future taxable income. The federal and state carryforwards have expiration dates beginning in 2012 and 2007,
respectively, in each case if not utilized.



At December 31, 2003, we had tax
credits carryforwards of approximately $1,218,000 and $1,262,000 for federal and state income tax purposes, respectively. If not utilized, the federal research and development tax credit carryforwards will expire beginning in 2012. The state
research and development tax credit can be carried forward indefinitely.



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



At December 31, 2003, the Company had approximately $1,200,000 of net
operating losses in the foreign operations, which can be carried forward indefinitely, absent any changes in control.



64



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KYPHON INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



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



|                                                                      |  |              |        |      |   |         |  
|--------------------------------------------------------------------- |  | ------------ | ------ | ---- | - | ------- | -
|                                                                      |  | December 31, |       
|                                                                      |  | 2003         |        | 2002 |  
|Net operating loss carryforwards                                      |  | $            | 13,850 |      | $ | 11,188  |  
|Research and development credit carryforwards                         |  |              | 2,051  |      |   | 1,341   |  
|Capitalized research and development costs                            |  |              | 491    |      |   | 744     |  
|Purchased research and development                                    |  |              | 4,070  |      |   | 4,763   |  
|Other accruals and reserves not currently deductible for tax purposes |  |              | 1,163  |      |   | 2,362   |  
|                                                                      |  |              |        |      |   |         |  
|                                                                      |  |              | 21,625 |      |   | 20,398  |  
|Less: Valuation allowance                                             |  |              |       |      |   | (20,398 | )
|                                                                      |  |              |        |      |   |         |  
|Total deferred tax assets                                             |  | $            | 21,625 |      | $ |        |  
|                                                                      |  |              |        |      |   |         |  



Management periodically evaluates the
recoverability of the deferred tax assets and recognizes the tax benefit only as reassessment demonstrates that they are realizable. At such time, if it is determined that it is more likely than not that the deferred tax assets are realizable, the
valuation allowance will be adjusted. At December 31, 2002, the Company provided a valuation allowance against its deferred tax assets due to the uncertainty regarding their realizability. As of December 31, 2003, the Company has released the
valuation allowance 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 a provision (benefit) computed at the U.S. statutory tax rate as follows:



|                                                |  |                          |    |  |       |    |  |       |   
|----------------------------------------------- |  | ------------------------ | -- |  | ----- | -- |  | ----- | --
|                                                |  | Years Ended December 31, |   
|                                                |  | 2003                     |    |  | 2002  |    |  | 2001  |   
|Federal statutory rate                          |  | 34.0                     | %  |  | (34.0 | )% |  | (34.0 | )%
|State, net of federal benefit                   |  | 5.8                      |    |  | (5.8  | )  |  | (5.3  | ) 
|Deferred stock compensation, net of tax benefit |  | (35.7                    | )  |  |      |    |  |      |   
|Tax reserves                                    |  | 30.6                     |    |  |      |    |  |      |   
|Other permanent difference                      |  | 1.6                      |    |  | 13.3  |    |  | 6.2   |   
|Change in valuation allowance                   |  | (142.0                   | )  |  | 32.2  |    |  | 3.6   |   
|Net operating loss (utilization)                |  |                         |    |  | (5.5  | )  |  | (29.5 | ) 
|Tax credits (utilization)                       |  |                         |    |  | (0.2  | )  |  |      |   
|                                                |  |                          |    |  |       |    |  |       |   
|Total benefit for income taxes                  |  | (105.7                   | )% |  | 0.0   | %  |  | 0.0   | % 
|                                                |  |                          |    |  |       |    |  |       |   



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KYPHON INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  (Continued)



15. QUARTERLY FINANCIAL DATA (UNAUDITED)



The following tables contain selected unaudited Consolidated Statement of Operations data for each quarter of 2003 and 2002 (in thousands,
except per share amounts):



|                                     |  |                         |        |   |          |   |           |  |          |        |  |   |        |  
|------------------------------------ |  | ----------------------- | ------ | - | -------- | - | --------- |  | -------- | ------ |  | - | ------ | -
|                                     |  | Year 2003 Quarter Ended |       
|                                     |  | Mar. 31,                |        |   | June 30, |   | Sept. 30, |  | Dec. 31, |       
|Net sales                            |  | $                       | 25,137 |   |          | $ | 31,081    |  | $        | 35,145 |  | $ | 39,665 |  
|Gross profit                         |  |                         | 21,787 |   |          |   | 27,131    |  |          | 30,554 |  |   | 34,762 |  
|Net income                           |  | $                       | 541    | * |          | $ | 2,820     |  | $        | 4,712  |  | $ | 19,250 | ^
|Net income per share:                |  |                         |        |   |          |   |           |  |          |        |  |   |        |  
|Basic                                |  | $                       | 0.01   |   |          | $ | 0.07      |  | $        | 0.12   |  | $ | 0.49   |  
|Diluted                              |  | $                       | 0.01   |   |          | $ | 0.07      |  | $        | 0.11   |  | $ | 0.45   |  
|Weighted-average shares outstanding: |  |                         |        |   |          |   |           |  |          |        |  |   |        |  
|Basic                                |  |                         | 37,566 |   |          |   | 38,069    |  |          | 38,767 |  |   | 39,298 |  
|Diluted                              |  |                         | 40,895 |   |          |   | 41,429    |  |          | 42,539 |  |   | 43,082 |  

---

|* | Net income includes purchased in-process research and development expense of $636,000.
|- | --------------------------------------------------------------------------------------

|^ | Net income includes lease termination cost of $1,200,000 and income tax benefit of $14,500,000.
|- | -----------------------------------------------------------------------------------------------



|                                     |  |                         |        |   |          |   |        |           |  |   |          |    |  |   |       
|------------------------------------ |  | ----------------------- | ------ | - | -------- | - | ------ | --------- |  | - | -------- | -- |  | - | ------
|                                     |  | Year 2002 Quarter Ended
|                                     |  | Mar. 31,                |        |   | June 30, |   |        | Sept. 30, |  |   | Dec. 31,
|Net sales                            |  | $                       | 14,594 |   |          | $ | 18,238 |           |  | $ | 20,744   |    |  | $ | 22,740
|Gross profit                         |  |                         | 12,324 |   |          |   | 15,845 |           |  |   | 17,897   |    |  |   | 19,834
|Net income (loss)                    |  | $                       | (1,668 | ) |          | $ | (2,961 | )         |  | $ | (11,627  | )* |  | $ | 918   
|Net income (loss) per share:         |  |                         |        |   |          |   |        |           |  |   |          |    |  |   |       
|Basic                                |  | $                       | (0.58  | ) |          | $ | (0.15  | )         |  | $ | (0.32    | )  |  | $ | 0.02  
|Diluted                              |  | $                       | (0.58  | ) |          | $ | (0.15  | )         |  | $ | (0.32    | )  |  | $ | 0.02  
|Weighted-average shares outstanding: |  |                         |        |   |          |   |        |           |  |   |          |    |  |   |       
|Basic                                |  |                         | 2,860  |   |          |   | 19,304 |           |  |   | 36,741   |    |  |   | 37,033
|Diluted                              |  |                         | 2,860  |   |          |   | 19,304 |           |  |   | 36,741   |    |  |   | 40,668

---

|* | Net loss includes purchased in-process research and development expense of $12,250,000.
|- | ---------------------------------------------------------------------------------------



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REPORT OF INDEPENDENT AUDITORS ON FINANCIAL STATEMENT SCHEDULE



To the Board of Directors

of Kyphon Inc.:



Our audits of the consolidated financial statements referred to in our report dated March 9, 2004 appearing in this Annual Report on Form
10-K also included an audit of the financial statement schedule listed in Item 15(a)(2) of this Form 10-K. In our opinion, the financial statement schedule presents fairly, in all material respects, the information set forth therein when read in
conjunction with the related consolidated financial statements.



/s/
PricewaterhouseCoopers LLP



San Jose, California

March 9, 2004



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KYPHON INC.

SCHEDULE II

VALUATION AND QUALIFYING ACCOUNTS

FOR THE YEARS ENDED DECEMBER 31, 2001, 2002 AND 2003

(in thousands)



|                                             |  |                            |        |                              |       |            |        |                       |   |       
|-------------------------------------------- |  | -------------------------- | ------ | ---------------------------- | ----- | ---------- | ------ | --------------------- | - | ------
|Description                                  |  | Balanceat Beginningof Year |        | Charged to Costs andExpenses |       | Deductions |        | Balance at End ofYear
|Allowance for doubtful accounts receivable:  |  |                            |        |                              |       |            |        |                       |   |       
|Fiscal year ended 2001                       |  | $                          | 80     |                              | 20    |            |       |                       | $ | 100   
|Fiscal year ended 2002                       |  |                            | 100    |                              | 3     |            | 3      |                       |   | 100   
|Fiscal year ended 2003                       |  | $                          | 100    |                              | 404   |            | 4      |                       | $ | 500   
|                                             |  |                            |        |                             
|Allowance for inventories valuation:         |  |                            |        |                              |       |            |        |                       |   |       
|Fiscal year ended 2001                       |  | $                          | 182    |                              | 95    |            | 86     |                       | $ | 191   
|Fiscal year ended 2002                       |  |                            | 191    |                              | 470   |            | 54     |                       |   | 607   
|Fiscal year ended 2003                       |  | $                          | 607    |                              | 550   |            | 532    |                       | $ | 625   
|                                             |  |                            |        |                             
|Valuation allowance for deferred tax assets: |  |                            |        |                              |       |            |        |                       |   |       
|Fiscal year ended 2001                       |  | $                          | 10,175 |                              | 5,074 |            |       |                       | $ | 15,249
|Fiscal year ended 2002                       |  |                            | 15,249 |                              | 5,149 |            |       |                       |   | 20,398
|Fiscal year ended 2003                       |  | $                          | 20,398 |                              |      |            | 20,398 |                       | $ |      



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



Not applicable.



|ITEM 9A. |  | CONTROLS AND PROCEDURES
|-------- |  | -----------------------



An evaluation of the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934) as of the end of the
period covered by this report was carried out under the supervision and with the participation of our management, including our chief executive officer and chief financial officer. Based on that evaluation, our chief executive officer and chief
financial officer have concluded that our disclosure controls and procedures are effective to ensure that material information relating to us, including our consolidated subsidiaries, is made known to them by others within such entities,
particularly during the period in which this report was prepared, in order to allow timely decisions regarding required disclosure.



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



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 2004 Annual Meeting of Stockholders to be filed with the
Securities and Exchange Commission within 120 days after the end of our 2003 fiscal year (the 2004 Proxy Statement).



|ITEM 11. |  | EXECUTIVE COMPENSATION
|-------- |  | ----------------------



The information required by this Item is incorporated by reference to the 2004 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 2004 Proxy Statement.



|ITEM 13. |  | CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
|-------- |  | ----------------------------------------------



The information required by this Item is incorporated by reference to the 2004 Proxy Statement.



|ITEM 14. |  | PRINCIPAL ACCOUNTANT FEES AND SERVICES
|-------- |  | --------------------------------------



The information required by this Item is incorporated by reference to the 2004 Proxy Statement.



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PART IV



|ITEM 15. |  | EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
|-------- |  | ---------------------------------------------------------------



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



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



(3) Exhibits



|          |  |                                                                                                                                                                                
|--------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Number    |  | Description                                                                                                                                                                    
|3.2(1)    |  | Amended and Restated Certificate of Incorporation of the Registrant.                                                                                                           
|          | 
|3.4(1)    |  | Bylaws of the Registrant.                                                                                                                                                      
|          | 
|4.1(1)    |  | Specimen common stock certificate of the Registrant.                                                                                                                           
|          | 
|10.1*(1)  |  | Form of Indemnification Agreement for directors and executive officers.                                                                                                        
|          | 
|10.2*(1)  |  | 1996 Stock Option Plan, including form of option agreement.                                                                                                                    
|          | 
|10.3*(1)  |  | 2002 Stock Plan, including form of option agreement.                                                                                                                           
|          | 
|10.4*(1)  |  | 2002 Employee Stock Purchase Plan, including form of employee stock purchase plan subscription agreement.                                                                      
|          | 
|10.5*(1)  |  | 2002 Director Option Plan, including form of option agreement.                                                                                                                 
|          | 
|10.8(1)   |  | Lease dated January 27, 2000 for office space located at 1350 Bordeaux Drive, Sunnyvale, CA 94089 and Second Amendment to Lease dated November 29, 2001.                       
|          | 
|10.8.1(1) |  | Third Amendment to Lease dated March 29, 2002 for office space located at 1350 Bordeaux Drive, Sunnyvale, CA 94089.                                                            
|          | 
|10.9*(1)  |  | Employment Agreement between the Registrant and Gary L. Grenter dated July 16, 2001.                                                                                           
|          | 
|10.10(1)  |  | Promissory Note Secured by Deed of Trust between the Registrant and Gary L. Grenter dated December 31, 2001.                                                                   
|          | 
|10.11(1)  |  | Amended and Restated Stockholder Rights Agreement effective as of December 14, 1999, among the Registrant and certain stockholders of the Registrant.                          
|          | 
|10.12*(2) |  | Employment Agreement between the Registrant and Richard W. Mott dated September 3, 2002.                                                                                       
|          | 
|10.13(2) |  | Sublicense Agreement effective as of August 19, 2002, between the Registrant and Bonutti Research, Inc.                                                                        
|          | 
|10.14(3)  |  | Stock Purchase Agreement by and between Kyphon and the shareholders of Sanatis GmbH, dated February 15, 2003.                                                                  
|          | 
|10.15(4)  |  | Lease dated September 18, 2003 for office spaces located at 1221 Crossman Avenue and 480 Java Drive, Sunnyvale, California.                                                    
|          | 
|23.1      |  | Consent of PricewaterhouseCoopers LLP                                                                                                                                          
|          | 
|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.



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---

|(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 Form 10-Q filed on November 13, 2002.
|--- | ------------------------------------------------------------------------

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

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

|* | 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.
|- | -------------------------------------------------------------------------------------------------------------------------------------------------



|(b) | Reports on Form 8-K.
|--- | --------------------



| |  | On October 29, 2003, we furnished a Form 8-K under Item 12 regarding our press release announcing our third quarter 2003 results.
| | - | ---------------------------------------------------------------------------------------------------------------------------------



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##### Table of Contents

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 10th day of March,
2004.



Kyphon Inc.By:

/s/ Richard W. MottRichard W. MottPresident, Chief Executive Officer and Director(Principal Executive Officer)




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



Pursuant to the requirements of the Securities Act of 1933, this Registration Statement has been signed by the following persons in the capacities and on the dates indicated:



|                                                     |  |                                                                                                                                  |  |               
|---------------------------------------------------- |  | -------------------------------------------------------------------------------------------------------------------------------- |  | --------------
|Signature                                            |  | Title                                                                                                                            |  | Date          
|                                                     |  |                                                                                                                                 
|/s/ RICHARD W. MOTTRichard W. Mott                   |  | President, Chief Executive Officer and Director (Principal Executive Officer)                                                    |  | March 10, 2004
|                                                     |  |                                                                                                                                 
|/s/ JEFFREY L. KAISERJeffrey L. Kaiser               |  | Vice President of Finance and Administration, Treasurer and Chief Financial Officer (Principal Accounting and Financial
Officer) |  | March 10, 2004
|                                                     |  |                                                                                                                                 
|/s/ JAMES T. TREACEJames T. Treace                   |  | Chairman of the Board                                                                                                            |  | March 10, 2004
|                                                     |  |                                                                                                                                 
|/s/ STEPHEN CAMPEStephen Campe                       |  | Director                                                                                                                         |  | March 10, 2004
|                                                     |  |                                                                                                                                 
|/s/ DOUGLAS W. KOHRSDouglas W. Kohrs                 |  | Director                                                                                                                         |  | March 10, 2004
|                                                     |  |                                                                                                                                 
|/s/ JACK W. LASERSOHNJack W. Lasersohn               |  | Director                                                                                                                         |  | March 10, 2004
|                                                     |  |                                                                                                                                 
|/s/ KAREN D. TALMADGE, PH.D.Karen D. Talmadge, Ph.D. |  | Director                                                                                                                         |  | March 10, 2004
|                                                     |  |                                                                                                                                 
|/s/ ELIZABETH H. WEATHERMANElizabeth H. Weatherman   |  | Director                                                                                                                         |  | March 10, 2004



72