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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
 Washington, D.C. 20549
 FORM 10-Q
 þ
    
    Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
 for the quarterly period ended September 30, 2006
 or
 o
    
    Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act
of 1934
 for the Transition Period from  to
 Commission File Number 0-19278
 OSTEOTECH, INC.
  Delaware
(State or other jurisdiction of 
incorporation or organization)
    
    13-3357370
(I.R.S. Employer Identification No.)
 51 James Way, Eatontown, New Jersey 07724
 (732) 542-2800
 Not Applicable
 þ o
  o þ o
 o þ




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##### Table of Contents



OSTEOTECH, INC.
 FORM 10-Q
 Table of Contents
 Page No.PART I. FINANCIAL INFORMATIONItem 1. Financial StatementsCondensed Consolidated Balance Sheets as of September
30, 2006 and December 31, 2005
    
    
    3Condensed Consolidated Statements of Operations for the
Three Months and Nine Months Ended September 30, 2006
and 2005
    
    
    4Condensed Consolidated Statements of Cash Flows for
the Nine Months Ended September 30, 2006 and 2005
    
    
    5Notes to Condensed Consolidated Financial Statements
    
    
    6Item 2. Managements Discussion and Analysis of Financial Condition
and Results of Operations
    
    
    15Item 3. Quantitative and Qualitative Disclosures About Market Risks
    
    
    23Item 4. Controls and Procedures
    
    
    23PART II. OTHER INFORMATIONItem 1. Legal Proceedings
    
    
    25Item 6. Exhibits
    
    
    25EX-31.1: CERTIFICTIONEX-31.2: CERTIFICTIONEX-32.1: CERTIFICTIONEX-32.1: CERTIFICTION
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PART I. FINANCIAL INFORMATION
 
 Item 1. FINANCIAL STATEMENTS
 OSTEOTECH,
INC. and SUBSIDIARIES
 
 CONDENSED CONSOLIDATED BALANCE SHEETS
 (dollars in thousands)
 September 30,
    
    December 31,2006
    
    2005(Unaudited)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    14,892
    
    
    $
    13,484Accounts receivable, net of allowance of $438 in 2006
and $1,131 in 2005
    
    
    16,737
    
    
    
    14,879Deferred processing costs
    
    
    28,458
    
    
    
    28,805Inventories
    
    
    1,170
    
    
    
    1,278Prepaid expenses and other current assets
    
    
    3,110
    
    
    
    3,438Total current assets
    
    
    64,367
    
    
    
    61,884Property, plant and equipment, net
    
    
    37,250
    
    
    
    39,962Other assets
    
    
    8,521
    
    
    
    9,176Total assets
    
    $
    110,138
    
    
    $
    111,022LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable and accrued liabilities
    
    $
    14,643
    
    
    $
    16,320Current maturities of capital lease obligation
    
    
    708
    
    
    
    655Total current liabilities
    
    
    15,351
    
    
    
    16,975Capital lease obligation
    
    
    15,065
    
    
    
    15,603Other liabilities
    
    
    7,270
    
    
    
    7,689Total liabilities
    
    
    37,686
    
    
    
    40,267Commitments and contingenciesStockholders equity:Preferred stock, $.01 par value; 5,000,000 shares
authorized; no shares issued or outstanding
Common stock, $.01 par value; 70,000,000 shares
authorized; issued and outstanding 17,306,649 shares
in 2006 and 17,259,964 shares in 2005
    
    
    173
    
    
    
    173Additional paid-in capital
    
    
    65,263
    
    
    
    64,915Accumulated other comprehensive income
    
    
    780
    
    
    
    793Retained earnings
    
    
    6,236
    
    
    
    4,874Total stockholders equity
    
    
    72,452
    
    
    
    70,755Total liabilities and stockholders equity
    
    $
    110,138
    
    
    $
    111,022
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OSTEOTECH,
INC. and SUBSIDIARIES
 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
  (dollars in thousands, except per share data)
 Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2006
    
    2005
    
    2006
    
    2005Net revenues:Service
    
    $
    22,776
    
    
    $
    21,898
    
    
    $
    71,825
    
    
    $
    70,333Product
    
    
    672
    
    
    
    347
    
    
    
    1,985
    
    
    
    1,05023,448
    
    
    
    22,245
    
    
    
    73,810
    
    
    
    71,383Cost of services
    
    
    10,961
    
    
    
    15,107
    
    
    
    36,736
    
    
    
    43,280Cost of products
    
    
    917
    
    
    
    132
    
    
    
    1,865
    
    
    
    39711,878
    
    
    
    15,239
    
    
    
    38,601
    
    
    
    43,677Gross profit
    
    
    11,570
    
    
    
    7,006
    
    
    
    35,209
    
    
    
    27,706Marketing, selling, general and administrative
    
    
    9,751
    
    
    
    11,607
    
    
    
    29,856
    
    
    
    33,180Research and development
    
    
    1,192
    
    
    
    1,101
    
    
    
    3,507
    
    
    
    3,28710,943
    
    
    
    12,708
    
    
    
    33,363
    
    
    
    36,467Operating income (loss)
    
    
    627
    
    
    
    (5,702
    )
    
    
    1,846
    
    
    
    (8,761
    )Other expense:Interest expense, net
    
    
    (219
    )
    
    
    (394
    )
    
    
    (738
    )
    
    
    (546
    )Other
    
    
    (131
    )
    
    
    (25
    )
    
    
    359
    
    
    
    (847
    )(350
    )
    
    
    (419
    )
    
    
    (379
    )
    
    
    (1,393
    )Income (loss) before income taxes
    
    
    277
    
    
    
    (6,121
    )
    
    
    1,467
    
    
    
    (10,154
    )Income tax provision (benefit)
    
    
    (74
    )
    
    
    676
    
    
    
    105
    
    
    
    (647
    )Net income (loss)
    
    $
    351
    
    
    $
    (6,797
    )
    
    $
    1,362
    
    
    $
    (9,507
    )Earnings (loss) per share:Basic
    
    $
    .02
    
    
    $
    (.40
    )
    
    $
    .08
    
    
    $
    (.55
    )Diluted
    
    $
    .02
    
    
    $
    (.40
    )
    
    $
    .08
    
    
    $
    (.55
    )Shares used in computing earnings (loss) per
share:Basic
    
    
    17,295,314
    
    
    
    17,199,004
    
    
    
    17,281,703
    
    
    
    17,187,865Diluted
    
    
    17,352,420
    
    
    
    17,199,004
    
    
    
    17,356,109
    
    
    
    17,187,865
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OSTEOTECH, INC. and SUBSIDIARIES
 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
  (dollars in thousands)
 Nine Months EndedSeptember 30,2006
    
    2005Cash Flow From Operating ActivitiesNet income (loss)
    
    $
    1,362
    
    
    $
    (9,507
    )Adjustments to reconcile net income (loss)
to net cash provided by operating activities:Depreciation and amortization
    
    
    4,537
    
    
    
    4,285Share-based compensation expense
    
    
    162
    
    
    
    43Changes in current assets and liabilities:Accounts receivable
    
    
    (1,858
    )
    
    
    (2,563
    )Deferred processing costs
    
    
    269
    
    
    
    1,051Inventories
    
    
    108
    
    
    
    (194
    )Prepaid expenses and other current assets
    
    
    328
    
    
    
    2,703Note receivables from patent litigation settlement
    
    
    750
    
    
    
    750Accounts payable and other liabilities
    
    
    (2,105
    )
    
    
    6,335Net cash provided by operating activities
    
    
    3,553
    
    
    
    2,903Cash Flow From Investing ActivitiesCapital expenditures
    
    
    (1,509
    )
    
    
    (1,261
    )Proceeds from sale of land and building
    
    
    
    
    
    
    16,500Other, net
    
    
    (468
    )
    
    
    (383
    )Net cash provided by (used in) investing activities
    
    
    (1,977
    )
    
    
    14,856Cash Flow From Financing ActivitiesProceeds from issuance of common stock
    
    
    186
    
    
    
    133Principal payments on capital lease obligation
    
    
    (485
    )Principal payments on long-term debt
    
    
    
    
    
    
    (12,826
    )Net cash used in financing activities
    
    
    (299
    )
    
    
    (12,693
    )Effect of exchange rate changes on cash
    
    
    131
    
    
    
    (112
    )Net increase in cash and cash equivalents
    
    
    1,408
    
    
    
    4,954Cash and cash equivalents at beginning of period
    
    
    13,484
    
    
    
    13,391Cash and cash equivalents at end of period
    
    $
    14,892
    
    
    $
    18,345Supplementary cash flow data:Cash paid during the period for interest
    
    $
    1,260
    
    
    $
    427Cash paid during the period for taxes, net of refunds
    
    $
    76
    
    
    $
    (2,844
    )Non-cash financing and investing activities:Capital lease obligations
    
    
    
    
    
    $
    16,500Asset retirement obligation
    
    
    
    
    
    $
    1,339
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OSTEOTECH,
INC. and SUBSIDIARIES
 
 Notes to Unaudited Condensed Consolidated Financial Statements
 (dollars in thousands, except per share data)
 1. Basis of Presentation
 The accompanying condensed consolidated financial statements, other than the condensed consolidated
balance sheet at December 31, 2005, included herein are unaudited and reflect all adjustments
(consisting only of normal recurring accruals) considered necessary by management for a fair
statement of the consolidated financial position as of September 30, 2006, the consolidated results
of operations for the three months and nine months ended September 30, 2006 and 2005 and
consolidated cash flows for the nine months ended September 30, 2006 and 2005. The results of
operations and cash flows for the respective interim periods are not necessarily indicative of the
results to be expected for the full year. Certain prior year amounts within the consolidated
financial statements have been reclassified to conform to the 2006 presentation. The condensed
consolidated financial statement should be read in conjunction with the audited consolidated
financial statements, which were included as part of Osteotech, Inc.s (the Company) Annual
Report on Form 10-K for the year ended December 31, 2005.
 2. Recent Accounting Pronouncements
 In June 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 48,
Accounting for Uncertainty in Income Taxes-An interpretation of FASB Statement No. 109 (FIN
48), which clarifies the accounting for uncertainty in tax positions taken or expected to be taken
in a tax return. This guidance seeks to reduce the diversity in practice associated with certain
aspects of the recognition and measurement related to accounting for income taxes. The provisions
of FIN 48 are effective for the Company beginning January 1, 2007, with the cumulative effect of
the change in accounting principal, if any, recorded as an adjustment to opening retained earnings.
The Company is currently evaluating the impact of adopting FIN 48 on its financial position and
results of operations.In September 2006, the staff of the FASB issued Staff Position Aug Air-1, Accounting for Planned
Major Maintenance Activities (FSP). The FSP amends Accounting Principles Board Opinion No, 28,
Interim Financial Reporting (APB 28), and prohibits the accrue-in-advance method of accounting
for planned major maintenance activities in annual and interim financial reporting periods. The
Company does have a planned major maintenance activity associated with its annual or semi-annual
plant shutdowns. While early application is permitted, the provisions of the FSP are effective for
the Company beginning January 1, 2007. The guidance in the FSP shall be applied retrospectively for
all financial statements presented, unless it is impracticable to do so. The Company is currently
evaluating the impact of adopting the FSP on its financial position and results of operations.
Although the Company does not anticipate any impact on its historical annual financial results or
financial position, the Company does anticipate certain of its interim financial results and
financial position will be restated, with certain interim periods realizing improved earnings with
other interim periods realizing reduced earnings.In September 2006, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin
No. 108, Considering the Effects of Prior Year Misstatements when Qualifying Misstatements in
Current Year Financial Statements (SAB 108), which provides interpretive guidance on the
consideration of the effects of prior year misstatements in quantifying current year misstatements
for the purpose of a materiality assessment. The provisions of SAB 108 are effective for the
Company after November 15, 2006. Except for the changes potentially necessitated by the adoption
of the FSP noted above, we are not aware of any accounting changes or error corrections that may be
required in our historical financial statements.In September 2006, the FASB issued Statement of Financial Accounting Standards (SFAS) No. 157,
Fair Value Measurements (SFAS No. 157), which defines fair value, establishes a
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OSTEOTECH, INC. and SUBSIDIARIES
Notes to Unaudited Condensed Consolidated Financial Statements  (dollars in thousands, except per share data)
 framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements.
SFAS No. 157 applies under a number of other accounting pronouncements that require or permit fair value measurements.
The provisions of SFAS No. 157 are effective for the Company beginning January 1, 2008.
The Company is currently evaluating the impact of adopting SFAS No. 157 on its financial position and results of operations.
 3.
    
    Deferred Processing CostsDeferred processing costs consist of the following:
 September 30,
    
    December 31,2006
    
    2005Unprocessed donor tissue to be distributed
by the Company
    
    $
    10,183
    
    
    $
    8,896Tissue in process
    
    
    6,228
    
    
    
    4,621Implantable donor tissue to be distributed
by the Company
    
    
    11,382
    
    
    
    14,492Implantable donor tissue held for clients
    
    
    665
    
    
    
    796$
    28,458
    
    
    $
    28,805
 Unprocessed donor tissue to be distributed by the Company represents the value of such allograft
bone tissue expected to be processed within the next year. Unprocessed donor tissue to be
distributed by the Company expected to be processed in periods subsequent to one year of $3,456 and
$3,378 at September 30, 2006 and December 31, 2005, respectively, was reflected in other assets.
 4.
    
    InventoriesInventories consist of the following:
 September 30,
    
    December 31,2006
    
    2005Supplies
    
    $
    182
    
    
    $
    194Raw materials
    
    
    677
    
    
    
    813Finished goods
    
    
    311
    
    
    
    271$
    1,170
    
    
    $
    1,278
 5.
    
    Stock Compensation PlansThe Companys stock compensation plan (the 2000 Stock Plan), authorizes the grant of up to
2,250,000 shares of the Companys unissued common stock in the form of incentive stock options,
non-qualified stock options or other share-based awards to eligible employees, directors and
consultants. Incentive stock options may be granted at prices not less than 100% of the fair
market value on the date of grant. Non-qualified stock options, restricted stock units (RSUs)
and other share-based awards may be granted at the discretion of the Compensation Committee of the
Board of Directors under terms and conditions as determined by the Compensation Committee. RSUs
entitle the holder to receive, at a specified future date, a specified or determinable number of
shares of common stock. Options and RSUs issued pursuant to the 2000 Stock Plan typically have
terms requiring vesting ratable over four years, except for options or RSUs issued to non-employee
directors for which the vesting period is one year, or such other period to match the vesting
period or adjusted vesting period determined by the Companys Compensation Committee or Board of
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OSTEOTECH, INC. and SUBSIDIARIES
Notes to Unaudited Condensed Consolidated Financial Statements  (dollars in thousands, except per share data)
 Directors. The vesting term of options issued in the nine months ended September 30, 2006 had
ratable vesting over four years and the vesting terms of RSUs issued in the nine months ended
September 30, 2006 had ratable vesting over one to four years. All share-based awards have a
maximum contractual term of 10 years. The Company settles all share-based compensation awards with
newly issued shares. The 2000 Stock Plan replaced prior plans, except to the extent that options
issued under the prior plans continue to remain outstanding.The Company also has an employee stock purchase plan under which eligible employees have the
ability to purchase shares of the Companys common stock. The purchase price of the stock is 85%
of the fair market value of the stock on the last day of each quarter.Share-Based AwardsAs of January 1, 2006, we adopted SFAS No. 123(R), Share Based Payment (SFAS No. 123(R)) . The
adoption of SFAS No. 123(R) requires companies to recognize in the statement of operations the
grant-date fair value of stock options and other equity-based compensation issued to employees and
directors, including employee stock options, RSUs and employee stock purchases under an employee
stock purchase plan. SFAS No. 123(R) supersedes Accounting Principal Board Opinion No. 25,
Accounting for Stock Issued to Employees (APB No. 25), which we previously applied for all
periods prior to 2006.The Company adopted SFAS No. 123(R) using the modified prospective transition method, which
requires application of the accounting standard as of January 1, 2006, and the condensed
consolidated financial statements for all periods in 2006 reflect such impact. In accordance with
the modified prospective transition method, the consolidated financial statements for prior periods
have not been restated to reflect the impact of SFAS No. 123(R).In 2005 and 2004, the Companys Board of Directors initiated several actions to accelerate the
vesting of certain outstanding stock options. As a result, options representing 1,271,102 shares
of common stock were vested and the non-cash compensation expense related to these stock options
was reflected in our proforma disclosures required under SFAS No. 123, Accounting for Stock-Based
Compensation (SFAS No. 123). There was no non-cash compensation expense related to these stock
options that will impact 2006 or any other future period. For the three months and nine months
ended September 30, 2006, we recognized a non-cash compensation expense in the consolidated
statement of operations of $44 and $162, respectively, pursuant to the adoption of SFAS No. 123(R).
Non-cash share-based compensation for the three months and nine months ended September 30, 2006
resulted in no tax benefit to the Company as a result of the Companys providing a full valuation
reserve on deferred tax assets. At September 30, 2006, the unrecorded non-cash fair value based
compensation with respect to nonvested share-based awards was $331 and the weighted average period
over which that compensation will be charged to operations is 1.8 years.SFAS No. 123(R) requires companies to estimate the fair value of share-based payment awards issued
in the form of stock options on the date of grant using an option-pricing model. RSUs are valued at
the fair value of the underlying common stock on the date of grant. The value of the portion of the
award that is ultimately expected to vest is recognized as an expense over the requisite service
period. The Company is also required to establish the value of an additional paid-in capital pool
for tax impacts related to employee share-based compensation awards for which compensation costs
were reflected in our pro forma disclosures required under SFAS No. 123. The Company has not yet
completed the calculation of this pool, which is not required to be determined until the fourth
quarter of 2006, but the Company believes there will be no impact on our financial position or
results of operations from this calculation.
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OSTEOTECH, INC. and SUBSIDIARIES
Notes to Unaudited Condensed Consolidated Financial Statements  (dollars in thousands, except per share data)
     Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,Weighted Average Assumptions
    
    2005
    
    2006
    
    2005Expected holding period (years)
    
    
    5
    
    
    
    5
    
    
    
    5Risk-free interest rate
    
    
    3.47
    %
    
    
    4.71
    %
    
    
    3.72
    %Volatility factor
    
    
    76
    %
    
    
    75
    %
    
    
    77
    %Dividend yield
    
    
    0
    
    
    
    0
    
    
    
    0Annual forfeiture rate
    
    
    3
    %
    
    
    3
    %
    
    
    3
    %Fair value per share at date
of grant
    
    $
    2.91
    
    
    $
    3.25
    
    
    $
    2.34
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OSTEOTECH, INC. and SUBSIDIARIES
Notes to Unaudited Condensed Consolidated Financial Statements  (dollars in thousands, except per share data)
   Weighted AverageExercise Price perOptions
    
    Shares
    
    ShareOutstanding at January 1, 2006
    
    
    2,937,062
    
    
    $
    8.03Granted
    
    
    45,000
    
    
    $
    5.02Exercised
    
    
    (24,500
    )
    
    $
    3.79Forfeited
    
    
    (26,250
    )
    
    $
    3.67Expired
    
    
    (164,362
    )
    
    $
    6.57Outstanding at September 30, 2006
    
    
    2,766,950
    
    
    $
    8.14Exercisable at September 30, 2006
    
    
    2,669,450
    
    
    $
    8.28
   Weighted AverageGrant Date FairRestricted
    
    ValueStock Units
    
    Per ShareOutstanding at January 1, 2006
    
    
    0
    
    
    
    Granted
    
    
    40,000
    
    
    $
    3.92Vested
    
    
    0
    
    
    
    Forfeited
    
    
    (5,000
    )
    
    $
    3.93Unvested at September 30, 2006
    
    
    35,000
    
    
    $
    3.91
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OSTEOTECH, INC. and SUBSIDIARIES
Notes to Unaudited Condensed Consolidated Financial Statements  (dollars in thousands, except per share data)
 The following table sets forth pro forma net loss and net loss per share data for both basic and
diluted net loss per share assuming the adoption of SFAS No. 123(R) for the prior year periods
presented:
 Three Months
    
    Nine MonthsEnded
    
    EndedSeptember 30, 2005Net loss  as reported
    
    $
    (6,797
    )
    
    $
    (9,507
    )Impact on net loss related to share-based
employee compensation expense, net of
tax
    
    
    372
    
    
    
    1,892Net loss  pro forma
    
    $
    (7,169
    )
    
    $
    (11,399
    )Basic and diluted net loss per share:As reported
    
    $
    (.40
    )
    
    $
    (.55
    )Pro forma
    
    $
    (.42
    )
    
    $
    (.66
    )
 Stock Purchase PlanThe Companys employee stock purchase plan (the 1994 Purchase Plan) provides for the issuance of
up to 575,000 shares of Common Stock. Eligible employees may purchase shares of the Companys
Common Stock through payroll deductions of 1% to 71/2% of annual compensation. The purchase price
for the stock is 85% of the fair market value of the stock on the last day of each calendar
quarter. The 1994 Purchase Plan expires on July 1, 2009. At September 30, 2006, 108,823 shares
were available for future offerings under this plan. Non-cash compensation expense related to the
issuance of shares under this plan was not material to the consolidated statements of operations.6.
    
    Sale and Leaseback of Processing FacilityOn August 8, 2005, the Company completed the sale of its principal processing facility located in
Eatontown, New Jersey to an unrelated third party for $16.5 million in cash. The Company also
entered into an agreement to lease back the processing facility. The Company retained ownership of
all property and equipment, including leasehold improvements, directly related to the operation of
the Companys business. The transaction has been recorded as a capital lease, with the resulting
gain deferred and amortized in proportion to the amortization of the leased assets.The Company utilized a portion of the proceeds from the sale of the processing facility to repay
all outstanding bank debt as of August 8, 2005, of $10,963. All remaining proceeds of $5,323, net
of transaction costs of $214, arising from this transaction were available for general corporate
purposes.
 7.
    
    Debt and Financing ArrangementsThe Company had a credit facility which included a $5 million line of credit, a mortgage loan and
an equipment term loan. A portion of the proceeds from the sale and leaseback transaction for the
Companys principal processing facility were utilized to repay the then outstanding balance of the
mortgage and the equipment term loan. The line of credit, which had no amounts outstanding on
August 8, 2005, was cancelled resulting in the termination of the credit facility.8.
    
    Asset Retirement ObligationsSFAS No. 143, Accounting for Asset Retirement Obligations, requires the Company to record a
liability equal to the fair value of the estimated cost to retire an asset. The asset retirement
obligation (ARO) is recorded as a liability in the period in which the obligation is incurred or
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OSTEOTECH, INC. and SUBSIDIARIES
Notes to Unaudited Condensed Consolidated Financial Statements  (dollars in thousands, except per share data)
 becomes determinable (as defined in the standard) with a corresponding increase in the carrying
amount of the related long-lived asset. The ARO is accreted from its current discounted value to
its expected future settlement value, and the related capitalized cost is depreciated over the
useful life of the related long-lived asset. The ARO is based upon a number of assumptions
requiring professional judgment, including expected future settlement values and the
credit-adjusted risk free
interest rate, and future adjustments of these assumptions may have a material impact on the
Companys results of operations.An ARO was established in August 2005 concurrent with the sale and leaseback of the Companys
current processing facility. The initial value of the ARO, which was recorded as a long-term
liability, was approximately $1,339. The related capitalized cost has been included in property,
plant and equipment and will be amortized over the initial term of the lease.
 9.
    
    Commitments and ContingenciesLitigationThere were no material developments that occurred during the nine months ended September 30, 2006
in the lawsuits reported in the Companys Annual Report on Form 10-K for the year ended December
31, 2005, except for the settlement of the Tissue Transplant Technology, Ltd. action in February
2006, which was disclosed in the Companys 2005 Annual Report on From 10-K and which had no impact
on the Companys financial condition or results of operations. Additionally, one product liability
action was initiated against the Company, which is more fully discussed below. The Company is not
aware of any other matters or legal proceedings initiated against the Company during the first nine
months of 2006.Kment and Filan v. Osteotech, Inc.On or about May 8, 2006, the Company was served with a complaint in an action brought by plaintiffs
Karl Anthony Kment and Marie Filan in the United States District Court, District of Oregon. The
complaint alleges that plaintiffs suffered post-operative injuries in conjunction with failed
cervical fusions resulting from defective Osteotech Graftech® Bio-implants that were surgically
implanted in plaintiffs in October 2004. Plaintiffs assert personal injury claims for negligence
and strict products liability. Plaintiffs allege economic damages of not less than $80,000 each and
non-economic damages of $1,000,000 each, and thus together seek damages totaling at least
$2,160,000. The Company served an answer to the complaint on July 5, 2006. Discovery in this action
is in progress.The Company maintains a product liability insurance policy and notified the insurance company of
this action. The insurance company has agreed to defend the Company in this matter. The Company
believes that the claims made against it in this action are without merit and will vigorously
defend against such claims.Litigation is subject to many uncertainties and management is unable to predict the outcome of the
pending suits and claims. It is possible that the results of operations or liquidity and capital
resources of the Company could be adversely affected by the ultimate outcome of the pending
litigation or as a result of the costs of contesting such lawsuits. The Company is currently
unable to estimate the ultimate liability, if any, that may result from the pending litigation and,
accordingly, no material provision for any liability (except for accrued legal costs for services
previously rendered) has been made for such pending litigation in the consolidated financial
statements.
 -12-




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##### Table of Contents



OSTEOTECH, INC. and SUBSIDIARIES
Notes to Unaudited Condensed Consolidated Financial Statements  (dollars in thousands, except per share data)
 10.
    
    Comprehensive Income (Loss)Comprehensive income (loss) for the periods indicated is as follows:
 Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2006
    
    2005
    
    2006
    
    2005Net income (loss)
    
    $
    351
    
    
    $
    (6,797
    )
    
    $
    1,362
    
    
    $
    (9,507
    )Currency translation
adjustments
    
    
    (283
    )
    
    
    (897
    )
    
    
    (13
    )
    
    
    29Comprehensive income (loss)
    
    $
    68
    
    
    $
    (7,694
    )
    
    $
    1,349
    
    
    $
    (9,478
    )
 11.
    
    Earnings (Loss) Per ShareThe following table sets forth the computation of basic and diluted earnings (loss) per share for
the periods indicated:
 Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2006
    
    2005
    
    2006
    
    2005Net income (loss) available to
common stockholders
    
    $
    351
    
    
    $
    (6,797
    )
    
    $
    1,362
    
    
    $
    (9,507
    )Denominator for basic earnings
(loss) per share, weighted
average common shares
outstanding
    
    
    17,295,314
    
    
    
    17,199,004
    
    
    
    17,281,703
    
    
    
    17,187,865Effect of dilutive securities:Restricted stock units
    
    
    31,630
    
    
    
    
    
    
    
    11,758Stock options after
application of treasury stock
method
    
    
    25,476
    
    
    
    
    
    
    
    62,648Denominator for diluted income
(loss) per share
    
    
    17,352,420
    
    
    
    17,199,004
    
    
    
    17,356,109
    
    
    
    17,187,865Basic earnings (loss) per share
    
    $
    .02
    
    
    $
    (.40
    )
    
    $
    .08
    
    
    $
    (.55
    )Diluted earnings (loss) per share
    
    $
    .02
    
    
    $
    (.40
    )
    
    $
    .08
    
    
    $
    (.55
    )
 For the three months and nine months ended September 30, 2006 outstanding options to purchase
2,500,575 and 2,360,575 shares, respectively, of common stock were not included in the computation
of diluted earnings per share primarily because the options exercise prices were greater than the
average market price of the common stock and, therefore, the effect would be antidilutive. At
September 30, 2005, options to purchase 2,925,162 shares of common stock were not included in the
calculations of diluted net loss per share as the effect thereof would be antidilutive.
 -13-




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##### Table of Contents



OSTEOTECH, INC. and SUBSIDIARIES
Notes to Unaudited Condensed Consolidated Financial Statements  (dollars in thousands, except per share data)
 12.
    
    Operating Segments
  Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2006
    
    2005
    
    2006
    
    2005Revenues:DBM Segment
    
    $
    12,771
    
    
    $
    12,507
    
    
    $
    40,972
    
    
    $
    39,414Base Tissue Segment
    
    
    10,005
    
    
    
    9,391
    
    
    
    30,853
    
    
    
    30,919Other
    
    
    672
    
    
    
    347
    
    
    
    1,985
    
    
    
    1,050Consolidated
    
    $
    23,448
    
    
    $
    22,245
    
    
    $
    73,810
    
    
    $
    71,383Operating income (loss):DBM Segment
    
    $
    (216
    )
    
    $
    (586
    )
    
    $
    1,856
    
    
    $
    1,297Base Tissue Segment
    
    
    1,698
    
    
    
    (5,352
    )
    
    
    1,729
    
    
    
    (10,263
    )Other
    
    
    (855
    )
    
    
    236
    
    
    
    (1,739
    )
    
    
    205Consolidated
    
    $
    627
    
    
    $
    (5,702
    )
    
    $
    1,846
    
    
    $
    (8,761
    )
  13.
    
    Other Expense
   -14-




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##### Table of Contents



Item 2.
    
    MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
  FOR THE THREE MONTHS AND NINE MONTHS ENDED SEPTEMBER 30, 2006 AND 2005
 Results of Operations
 Critical Accounting Policies and Estimates
  Net Income (Loss)
 Three Months Ended September 30,
    
    Nine Months Ended September 30,(dollars in thousands,
    
    
    
    
    
    
    
    
    
    
    
    
    
    Percent
    
    
    
    
    
    
    
    
    
    
    
    
    
    Percentexcept per share amounts)
    
    2006
    
    2005
    
    Change
    
    Change
    
    2006
    
    2005
    
    Change
    
    ChangeNet income (loss)
    
    $
    351
    
    
    $
    (6,797
    )
    
    $
    7,148
    
    
    
    105
    %
    
    $
    1,362
    
    
    $
    (9,507
    )
    
    $
    10,869
    
    
    
    114
    %Earnings (loss) per share:Basic
    
    $
    .02
    
    
    $
    (.40
    )
    
    
    
    
    
    
    
    
    
    $
    .08
    
    
    $
    (.55
    )Diluted
    
    $
    .02
    
    
    $
    (.40
    )
    
    
    
    
    
    
    
    
    
    $
    .08
    
    
    $
    (.55
    )
   -15-




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##### Table of Contents



Net Revenues
   Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,Percent
    
    
    
    
    
    
    
    
    
    
    
    
    
    Percent(dollars in thousands)
    
    2006
    
    2005
    
    Change
    
    Change
    
    2006
    
    2005
    
    Change
    
    ChangeDBM SegmentDomestic
    
    $
    10,777
    
    
    $
    10,399
    
    
    $
    378
    
    
    
    4
    %
    
    $
    34,476
    
    
    $
    33,157
    
    
    $
    1,319
    
    
    
    4
    %International
    
    
    1,994
    
    
    
    2,108
    
    
    
    (114
    )
    
    
    (5
    )%
    
    
    6,496
    
    
    
    6,257
    
    
    
    239
    
    
    
    4
    %Total DBM Segment
    
    
    12,771
    
    
    
    12,507
    
    
    
    264
    
    
    
    2
    %
    
    
    40,972
    
    
    
    39,414
    
    
    
    1,558
    
    
    
    4
    %Base Tissue SegmentDomestic:Client Processing
    
    
    2,223
    
    
    
    2,388
    
    
    
    (165
    )
    
    
    (7
    )%
    
    
    6,226
    
    
    
    9,029
    
    
    
    (2,803
    )
    
    
    (31
    )%Traditional Tissue
    
    
    2,895
    
    
    
    1,950
    
    
    
    945
    
    
    
    48
    %
    
    
    8,357
    
    
    
    4,959
    
    
    
    3,398
    
    
    
    69
    %Graftech® Bio-implants
    
    
    3,118
    
    
    
    3,893
    
    
    
    (775
    )
    
    
    (20
    )%
    
    
    10,649
    
    
    
    13,164
    
    
    
    (2,515
    )
    
    
    (19
    )%8,236
    
    
    
    8,231
    
    
    
    5
    
    
    
    
    
    
    
    25,232
    
    
    
    27,152
    
    
    
    (1,920
    )
    
    
    (7
    )%International:Client Processing
    
    
    66
    
    
    
    110
    
    
    
    (44
    )
    
    
    (40
    )%
    
    
    451
    
    
    
    357
    
    
    
    94
    
    
    
    26
    %Traditional Tissue
    
    
    1,703
    
    
    
    1,050
    
    
    
    653
    
    
    
    62
    %
    
    
    5,170
    
    
    
    3,410
    
    
    
    1,760
    
    
    
    52
    %1,769
    
    
    
    1,160
    
    
    
    609
    
    
    
    53
    %
    
    
    5,621
    
    
    
    3,767
    
    
    
    1,854
    
    
    
    49
    %Total BaseTissue Segment
    
    
    10,005
    
    
    
    9,391
    
    
    
    614
    
    
    
    7
    %
    
    
    30,853
    
    
    
    30,919
    
    
    
    (66
    )
    
    
    Other Product Lines
    
    
    672
    
    
    
    347
    
    
    
    325
    
    
    
    94
    %
    
    
    1,985
    
    
    
    1,050
    
    
    
    935
    
    
    
    89
    %Net Revenues
    
    $
    23,448
    
    
    $
    22,245
    
    
    $
    1,203
    
    
    
    5
    %
    
    $
    73,810
    
    
    $
    71,383
    
    
    $
    2,427
    
    
    
    3
    %
 -16-




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Three Months Ended September 30, 2006
    Nine Months Ended September 30, 2006
    -17-




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##### Table of Contents



Gross Margin
 Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,(dollars in thousands)
    
    2006
    
    2005
    
    2006
    
    2005Gross Profit
    
    $
    11,570
    
    
    $
    7,006
    
    
    $
    35,209
    
    
    $
    27,706Gross Margin
    
    
    49
    %
    
    
    31
    %
    
    
    48
    %
    
    
    39
    %
  Operating Expenses
 Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,Percent
    
    
    
    
    
    
    
    
    
    
    
    
    
    Percent(dollars in thousands)
    
    2006
    
    2005
    
    Change
    
    Change
    
    2006
    
    2005
    
    Change
    
    ChangeMarketing, selling,
general
and administrative
    
    $
    9,751
    
    
    $
    11,607
    
    
    $
    (1,856
    )
    
    
    (16
    )%
    
    $
    29,856
    
    
    $
    33,180
    
    
    $
    (3,324
    )
    
    
    (10
    )%Research and
development
    
    
    1,192
    
    
    
    1,101
    
    
    
    91
    
    
    
    8
    %
    
    
    3,507
    
    
    
    3,287
    
    
    
    220
    
    
    
    7
    %Total
    
    $
    10,943
    
    
    $
    12,708
    
    
    $
    (1,765
    )
    
    
    (14
    )%
    
    $
    33,363
    
    
    $
    36,467
    
    
    $
    (3,104
    )
    
    
    (9
    )%
  ®
 -18-




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##### Table of Contents



Operating Income (Loss)
 Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,Percent
    
    
    
    
    
    
    
    
    
    
    
    
    
    Percent(dollars in thousands)
    
    2006
    
    2005
    
    Change
    
    Change
    
    2006
    
    2005
    
    Change
    
    ChangeDBM Segment
    
    $
    (216
    )
    
    $
    (586
    )
    
    $
    370
    
    
    
    63
    %
    
    $
    1,856
    
    
    $
    1,297
    
    
    $
    559
    
    
    
    43
    %Base Tissue Segment
    
    
    1,698
    
    
    
    (5,352
    )
    
    
    7,050
    
    
    
    132
    %
    
    
    1,729
    
    
    
    (10,263
    )
    
    
    11,992
    
    
    
    117
    %Other Product Lines
    
    
    (855
    )
    
    
    236
    
    
    
    (1,091
    )
    
    
    (462
    )%
    
    
    (1,739
    )
    
    
    205
    
    
    
    (1,944
    )
    
    
    (948
    )%Operating Income (loss)
    
    $
    627
    
    
    $
    (5,702
    )
    
    $
    6,329
    
    
    
    111
    %
    
    $
    1,846
    
    
    $
    (8,761
    )
    
    $
    10,607
    
    
    
    121
    %
   Other Expense
   -19-




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Income Tax Provision (Benefit)
   Share-Based Compensation
   Liquidity and Capital Resources
   -20-




---



##### Table of Contents



Recent Accounting Developments
    -21-




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##### Table of Contents



Contractual Obligations
  Impact of Inflation and Foreign Currency Exchange Fluctuations
  Litigation
   -22-




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##### Table of Contents



Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
  
 Item 4. CONTROLS AND PROCEDURES
 Evaluation of Disclosure Controls and Procedures
     1.
    
    In the third quarter of 2006, we completed a search for a senior level financial
manager with an appropriate level of accounting knowledge, experience and training in the
application of generally accepted accounting principles commensurate with our financial
and reporting requirements. In addition, in the first quarter of 2006, we hired an
additional senior staff accountant to assist in the preparation of journal entries and
account analyses and reconciliations. Also since the first quarter of 2006, our Executive
Vice President and Chief Financial Officer assumed additional review and oversight
responsibilities related to the financial closing process.
 -23-




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##### Table of Contents



2.
    
    We reorganized the reporting structures within our world-wide accounting and finance
functions to have the senior level managers report directly to our Executive Vice
President and Chief Financial Officer with indirect functional reporting to the
business managers.3.
    
    We provided and will continue to provide additional and expanded training and
education for all members of the worldwide accounting and finance functions, with an
emphasis on improving account analysis preparation and documentation. In the second
quarter of 2006, we prepared and presented a formal training program on work paper
documentation and preparation, which was attended by all members of the domestic and
corporate finance groups.4.
    
    We have made and will continue to make changes to our world-wide accounting
processes, policies and procedures. A number of changes have been made during the first
nine months of 2006 to improve the efficient use of our finance and accounting staff. We
expect to continue to make changes and improvements in the future.
  Changes in Internal Control Over Financial Reporting
  -24-




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##### Table of Contents



PART II. OTHER INFORMATION
 
 Item 1. LEGAL PROCEEDINGS
  
 Item 6. EXHIBITS
  Exhibit
    
    
    
    PageNumber
    
    Description
    
    Number31.1
    
    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
    
    Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002
    
    +32.2
    
    Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002
    
    +
 
 +
    
    Filed herewith -25-




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##### Table of Contents



SIGNATURES
  Date: November 3, 2006
    
    
    
    Osteotech, Inc.(Registrant)Date: November 3, 2006
    
    By:
    
    /s/ Sam Owusu-AkyawSam Owusu-AkyawPresident and Chief ExecutiveOfficer(Principal Executive Officer)Date: November 3, 2006
    
    By:
    
    /s/ Mark H. BurroughsMark H. BurroughsExecutive Vice President,Chief Financial Officer(Principal Financial Officer andChief Accounting Officer)
 -26-