##### Table of Contents



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 June 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




---



##### 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 June 30,
2006 and December 31, 2005
    
    
    3Condensed Consolidated Statements of Operations for the
Three Months and Six Months Ended June 30, 2006 and
2005
    
    
    4Condensed Consolidated Statements of Cash Flows for
the Six Months Ended June 30, 2006 and 2005
    
    
    5Notes to Condensed Consolidated Financial Statements
    
    
    6Item 2.
    
    Managements Discussion and Analysis of Financial Condition
and Results of Operations
    
    
    14Item 3.
    
    Quantitative and Qualitative Disclosures About Market Risks
    
    
    22Item 4.
    
    Controls and Procedures
    
    
    22PART II. OTHER INFORMATIONItem 1.
    
    Legal Proceedings
    
    
    24Item 4.
    
    Submission of Matters to a Vote of Security Holders
    
    
    24Item 5.
    
    Other Information
    
    
    24Item 6.
    
    Exhibits
    
    
    26EX-10.66: FORM OF 2000 STOCK PLAN RESTRICTED STOCK UNIT AGREEMENT FOR EMPLOYEESEX-10.67: FORM OF 2000 STOCK PLAN RESTRICTED STOCK UNIT AGREEMENT FOR INDEPENDENT DIRECTORSEX-10.68: FORM OF 2000 STOCK PLAN RESTRICTED STOCK UNIT AGREEMENT FOR CONSULTANTSEX-10.69: THE MANAGEMENT PERFORMANCE BONUS PLAN, JUNE 2006EX-31.1: CERTIFICATIONEX-31.2: CERTIFICATIONEX-32.1: CERTIFICATIONEX-32.2: CERTIFICATION
 -2-




---



##### Table of Contents



PART I. FINANCIAL INFORMATION
 
 Item 1. FINANCIAL STATEMENTS
 
 OSTEOTECH, INC. and SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS  (dollars in thousands)
 June 30,
    
    December 31,2006
    
    2005(Unaudited)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    13,813
    
    
    $
    13,484Accounts receivable, net of allowance of $423 in 2006
and $1,131 in 2005
    
    
    17,373
    
    
    
    14,879Deferred processing costs
    
    
    28,554
    
    
    
    28,805Inventories
    
    
    1,578
    
    
    
    1,278Prepaid expenses and other current assets
    
    
    3,550
    
    
    
    3,438Total current assets
    
    
    64,868
    
    
    
    61,884Property, plant and equipment, net
    
    
    38,605
    
    
    
    39,962Other assets
    
    
    8,468
    
    
    
    9,176Total assets
    
    $
    111,941
    
    
    $
    111,022LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable and accrued liabilities
    
    $
    16,309
    
    
    $
    16,320Current maturities of capital lease obligation
    
    
    690
    
    
    
    655Total current liabilities
    
    
    16,999
    
    
    
    16,975Capital lease obligation
    
    
    15,249
    
    
    
    15,603Other liabilities
    
    
    7,399
    
    
    
    7,689Total liabilities
    
    
    39,647
    
    
    
    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 17,294,621 shares
in 2006 and 17,259,964 shares in 2005
    
    
    173
    
    
    
    173Additional paid-in capital
    
    
    65,173
    
    
    
    64,915Accumulated other comprehensive income
    
    
    1,063
    
    
    
    793Retained earnings
    
    
    5,885
    
    
    
    4,874Total stockholders equity
    
    
    72,294
    
    
    
    70,755Total liabilities and stockholders equity
    
    $
    111,941
    
    
    $
    111,022
  -3-




---



##### Table of Contents



OSTEOTECH, INC. and SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS   (dollars in thousands, except per share data)
 Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2006
    
    2005
    
    2006
    
    2005Net revenues:Service
    
    $
    24,543
    
    
    $
    24,997
    
    
    $
    49,049
    
    
    $
    48,435Product
    
    
    739
    
    
    
    293
    
    
    
    1,313
    
    
    
    70325,282
    
    
    
    25,290
    
    
    
    50,362
    
    
    
    49,138Cost of services
    
    
    12,610
    
    
    
    15,110
    
    
    
    25,775
    
    
    
    28,173Cost of products
    
    
    612
    
    
    
    107
    
    
    
    948
    
    
    
    26513,222
    
    
    
    15,217
    
    
    
    26,723
    
    
    
    28,438Gross profit
    
    
    12,060
    
    
    
    10,073
    
    
    
    23,639
    
    
    
    20,700Marketing, selling, general and
administrative
    
    
    10,009
    
    
    
    10,967
    
    
    
    20,105
    
    
    
    21,573Research and development
    
    
    1,143
    
    
    
    1,224
    
    
    
    2,315
    
    
    
    2,18611,152
    
    
    
    12,191
    
    
    
    22,420
    
    
    
    23,759Operating income (loss)
    
    
    908
    
    
    
    (2,118
    )
    
    
    1,219
    
    
    
    (3,059
    )Other income (expense):Interest expense, net
    
    
    (249
    )
    
    
    (41
    )
    
    
    (519
    )
    
    
    (152
    )Other
    
    
    246
    
    
    
    (636
    )
    
    
    490
    
    
    
    (821
    )(3
    )
    
    
    (677
    )
    
    
    (29
    )
    
    
    (973
    )Income (loss) before income taxes
    
    
    905
    
    
    
    (2,795
    )
    
    
    1,190
    
    
    
    (4,032
    )Income tax provision (benefit)
    
    
    136
    
    
    
    (917
    )
    
    
    179
    
    
    
    (1,323
    )Net income (loss)
    
    $
    769
    
    
    $
    (1,878
    )
    
    $
    1,011
    
    
    $
    (2,709
    )Earnings (loss) per share:Basic
    
    $
    .04
    
    
    $
    (.11
    )
    
    $
    .06
    
    
    $
    (.16
    )Diluted
    
    $
    .04
    
    
    $
    (.11
    )
    
    $
    .06
    
    
    $
    (.16
    )Shares used in computing
earnings (loss) per share:Basic
    
    
    17,273,778
    
    
    
    17,187,792
    
    
    
    17,274,846
    
    
    
    17,182,245Diluted
    
    
    17,336,679
    
    
    
    17,187,792
    
    
    
    17,354,906
    
    
    
    17,182,245
  -4-




---



##### Table of Contents



OSTEOTECH, INC. and SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS   (dollars in thousands)
 Six Months EndedJune 30,2006
    
    2005Cash Flow From Operating ActivitiesNet income (loss)
    
    $
    1,011
    
    
    $
    (2,709
    )Adjustments to reconcile net income (loss)
to net cash provided by (used in) operating activities:Depreciation and amortization
    
    
    2,871
    
    
    
    2,799Share-based compensation expense
    
    
    118Changes in current assets and liabilities:Accounts receivable
    
    
    (2,494
    )
    
    
    (4,595
    )Deferred processing costs
    
    
    459
    
    
    
    1,434Inventories
    
    
    (300
    )
    
    
    (368
    )Prepaid expenses and other current assets
    
    
    (112
    )
    
    
    (1,386
    )Note receivables from patent litigation settlement
    
    
    500
    
    
    
    500Accounts payable and other liabilities
    
    
    (324
    )
    
    
    3,848Net cash provided by (used in) operating activities
    
    
    1,729
    
    
    
    (477
    )Cash Flow From Investing ActivitiesCapital expenditures
    
    
    (1,325
    )
    
    
    (459
    )Other, net
    
    
    (41
    )
    
    
    (139
    )Net cash used in investing activities
    
    
    (1,366
    )
    
    
    (598
    )Cash Flow From Financing ActivitiesProceeds from issuance of common stock
    
    
    140
    
    
    
    86Principal payments on capital lease obligation
    
    
    (319
    )Principal payments on long-term debt
    
    
    
    
    
    
    (1,330
    )Net cash used in financing activities
    
    
    (179
    )
    
    
    (1,244
    )Effect of exchange rate changes on cash
    
    
    145
    
    
    
    (113
    )Net increase (decrease) in cash and cash equivalents
    
    
    329
    
    
    
    (2,432
    )Cash and cash equivalents at beginning of period
    
    
    13,484
    
    
    
    13,391Cash and cash equivalents at end of period
    
    $
    13,813
    
    
    $
    10,959Supplementary cash flow data:Cash paid during the period for interest
    
    $
    844
    
    
    $
    321Cash paid during the period for taxes, net of refunds
    
    $
    27
    
    
    $
    561
  -5-




---



##### Table of Contents



OSTEOTECH, INC. and SUBSIDIARIES
Notes to Unaudited Condensed Consolidated Financial Statements  (dollars in thousands, except per share data)
 1.
    
    Basis of Presentation
  2.
    
    Recent Accounting Pronouncements
  3.
    
    Deferred Processing Costs
  June 30,
    
    December 31,2006
    
    2005Unprocessed donor tissue to be distributed
by the Company
    
    $
    9,799
    
    
    $
    8,896Tissue in process
    
    
    6,397
    
    
    
    4,621Implantable donor tissue to be distributed
by the Company
    
    
    11,724
    
    
    
    14,492Implantable donor tissue held for clients
    
    
    634
    
    
    
    796$
    28,554
    
    
    $
    28,805
  -6-




---



##### Table of Contents



OSTEOTECH, INC. and SUBSIDIARIES
Notes to Unaudited Condensed Consolidated Financial Statements  (dollars in thousands, except per share data)
 4.
    
    Inventories
 Inventories consist of the following:
 June 30,
    
    December 31,2006
    
    2005Supplies
    
    $
    183
    
    
    $
    194Raw materials
    
    
    796
    
    
    
    813Finished goods
    
    
    599
    
    
    
    271$
    1,578
    
    
    $
    1,278
 5.
    
    Stock Compensation Plans
 The 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 period to match the vesting period or
adjusted vesting period determined by the Companys Compensation Committee or Board of Directors.
The vesting term of options issued in the six months ended June 30, 2006 had ratable vesting over
four years and the vesting terms of RSUs issued in the six months ended June 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 value of the stock on the last day of each quarter.
 Share-Based Awards
 As of January 1, 2006, we adopted Statement of Financial Accounting Standard (SFAS) No. 123(R),
Share Based Payment. 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, 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 2005 and 2004,
the Companys Board of Directors initiated several actions to accelerate the vesting of certain
 -7-




---



##### Table of Contents



OSTEOTECH, INC. and SUBSIDIARIES
Notes to Unaudited Condensed Consolidated Financial Statements  (dollars in thousands, except per share data)
 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. There
was no non-cash compensation expense related to these stock options that will impact 2006 or any
other future period. 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). For the three months and six months ended June 30, 2006, we recognized a non-cash
compensation expense in the consolidated statement of operations of $57 and $118, respectively,
pursuant to the adoption of SFAS No. 123(R). Non-cash share-based compensation for the three
months and six months ended June 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 June 30, 2006 the
unrecorded non-cash fair value based compensation with respect to nonvested share-based awards was
$372 and the weighted average period over which that compensation will be charged to operations is
3.1 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 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.Share-based compensation expense recognized in our condensed consolidated statements of operations
for the three months and six months ended June 30, 2006 included compensation expense for
share-based payment awards granted prior to, but not yet vested as of January 1, 2006, as well as
compensation expense for the share-based payment awards granted subsequent to January 1, 2006.
Such share-based compensation expense was based on the grant date fair value estimated in
accordance with the provisions of SFAS No. 123(R). Share-based compensation expense recognized in
the condensed consolidated statements of operations for the three months and six months ended June
30, 2006 is based on awards ultimately expected to vest, and therefore has been reduced for
estimated forfeitures. SFAS No. 123(R) requires forfeitures to be estimated at the time of grant
and revised, if necessary, in subsequent periods if actual forfeitures differ materially from those
estimates. The Company recognizes the compensation cost of all share-based payment awards on a
straight-line basis over the vesting period of the individual award.Prior to the adoption of SFAS No. 123(R), we accounted for share-based payment awards using the
intrinsic value method in accordance with APB No. 25 as allowed under SFAS No. 123. Under the
intrinsic value method, no share-based compensation expense had been recognized in our condensed
consolidated statements of operations for periods prior to 2006 because the exercise price of our
stock options granted equaled the fair market value of the underlying stock at the date of grant.
In our pro forma disclosures required under SFAS No. 123 for the periods prior to 2006, we
estimated forfeitures and in subsequent periods adjusted forfeitures for actual amounts.For purposes of determining the estimated fair value of share-based payment awards issued in the
form of stock options, under SFAS No. 123(R) the Company utilizes the Black-Scholes option-pricing
model (Black-Scholes Model). The Black-Scholes Model requires the input of certain assumptions
that involve judgment. Because stock options have characteristics significantly different from
those of traded options, and because changes in the input assumptions can materially
 -8-




---



##### Table of Contents



OSTEOTECH, INC. and SUBSIDIARIES
Notes to Unaudited Condensed Consolidated Financial Statements  (dollars in thousands, except per share data)
 affect the
fair value estimate, the existing models may not provide a reliable single measure of the fair
value of the Companys stock options. Management will continue to assess the assumptions and
methodologies used to calculate estimated fair value under the Black-Scholes Model. Circumstances
may change and additional data may become available over time, which could
result in changes to these assumptions and methodologies, and thereby materially impact our fair
value determination.The fair value of each option granted during the three months and six months ended June 30, 2006
and 2005 was estimated on the grant-date using the Black-Scholes Model with the following weighted
average assumptions:
 Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,Weighted Average Assumptions
    
    2006
    
    2005
    
    2006
    
    2005Expected holding period (years)
    
    
    5
    
    
    
    5
    
    
    
    5
    
    
    
    5Risk-free interest rate
    
    
    5.02
    %
    
    
    3.79
    %
    
    
    4.71
    %
    
    
    3.81
    %Volatility factor
    
    
    75
    %
    
    
    77
    %
    
    
    75
    %
    
    
    77
    %Dividend yield
    
    
    0
    
    
    
    0
    
    
    
    0
    
    
    
    0Annual forfeiture rate
    
    
    3
    %
    
    
    3
    %
    
    
    3
    %
    
    
    3
    %Fair value per share at date of grant
    
    $
    2.82
    
    
    $
    2.10
    
    
    $
    3.25
    
    
    $
    2.13
 The expected holding period was determined based on managements assessment considering expected
experience and the Companys historical data. Volatility is estimated considering the historical
volatility of the Companys daily common stock price over a period similar to the expected holding
period of the option. The risk-free interest rate is based on U.S. Treasury rates appropriate for
the expected holding period of the option.The following table summarizes information concerning option transactions for the six months ended
June 30, 2006:
 Weighted AverageOptions
    
    Shares
    
    Exercise Price per ShareOutstanding at January 1, 2006
    
    
    2,937,062
    
    
    $
    8.03Granted
    
    
    45,000
    
    
    
    5.02Exercised
    
    
    (20,000
    )
    
    
    3.88Forfeited
    
    
    (15,000
    )
    
    
    4.46Expired
    
    
    (96,050
    )
    
    
    5.50Outstanding at June 30, 2006
    
    
    2,851,012
    
    
    $
    8.27Exercisable at June 30, 2006
    
    
    2,736,012
    
    
    $
    8.27
 At June 30, 2006, the aggregate intrinsic value of options outstanding and options exercisable was
$171 and $139, respectively. The weighted average remaining contractual term of options outstanding
and options exercisable at June 30, 2006 was 5.07 years and 4.89 years, respectively. The
aggregate intrinsic value represents the total pre-tax value, based on the Companys average stock
price as of June 30, 2006, which would have been received by the option holders had they exercised
their in-the-money options as of that date. During the six months ended June 30, 2006, 100,000
outstanding options vested and the intrinsic value of options exercised was $15.
 -9-




---



##### Table of Contents



OSTEOTECH, INC. and SUBSIDIARIES
Notes to Unaudited Condensed Consolidated Financial Statements  (dollars in thousands, except per share data)
 The Company issued RSUs for the first time in June 2006. The following table summarizes
information concerning RSU transactions for the six months ended June 30, 2006:
 Weighted Average GrantRestricted Stock
    
    Date Fair ValueUnits
    
    Per ShareOutstanding at January
1, 2006
    
    
    0
    
    
    
    Granted
    
    
    35,000
    
    
    $
    3.93Vested
    
    
    
    
    
    
    Forfeited
    
    
    (5,000
    )
    
    $
    3.93Unvested at June 30, 2006
    
    
    30,000
    
    
    $
    3.93
 At June 30, 2006, the Company had 269,675 shares of common stock reserved for future share-based
payment awards.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 Ended
    
    Six Months EndedJune 30, 2005Net loss  as reported
    
    $
    (1,878
    )
    
    $
    (2,709
    )Impact on net loss related to share-based
employee compensation expense, net of
tax
    
    
    1,003
    
    
    
    1,057Net loss  pro forma
    
    $
    (2,881
    )
    
    $
    (3,766
    )Basic and diluted net loss per share:As reported
    
    $
    (.11
    )
    
    $
    (.16
    )Pro forma
    
    $
    (.17
    )
    
    $
    (.22
    )
 Stock Purchase Plan
 The 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 June 30, 2006, 116,351 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.
 -10-




---



##### Table of Contents



OSTEOTECH, INC. and   (dollars in thousands, except per share data)
 6.
    
    Commitments and Contingencies
 LitigationThere were no material developments that occurred during the six months ended June 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. d/b/a Bone Bank Allograft
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, and the
initiation of one additional product liability action 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 six 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.
 -11-




---



##### Table of Contents



OSTEOTECH, INC.  and SUBSIDIARIES
Notes to Unaudited Condensed Consolidated Financial Statements  (dollars in thousands, except per share data)
 7.
    
    Comprehensive Income (Loss)Comprehensive income (loss) for the periods indicated is as follows:
 Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2006
    
    2005
    
    2006
    
    2005Net income (loss)
    
    $
    769
    
    
    $
    (1,878
    )
    
    $
    1,011
    
    
    $
    (2,709
    )Currency translation
adjustments
    
    
    347
    
    
    
    469
    
    
    
    270
    
    
    
    926Comprehensive income (loss)
    
    $
    1,116
    
    
    $
    (1,409
    )
    
    $
    1,281
    
    
    $
    (1,783
    )
 8.
    
    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
    
    Six Months EndedJune 30,
    
    June 30,2006
    
    2005
    
    2006
    
    2005Net income (loss) available to
common stockholders
    
    $
    769
    
    
    $
    (1,878
    )
    
    $
    1,011
    
    
    $
    (2,709
    )Denominator for basic earnings
(loss) per share, weighted
average common shares
outstanding
    
    
    17,273,778
    
    
    
    17,187,792
    
    
    
    17,274,846
    
    
    
    17,182,245Effect of dilutive securities:RSUs
    
    
    2,967
    
    
    
    
    
    
    
    1,492Stock options after
application of treasury stock
method
    
    
    59,934
    
    
    
    
    
    
    
    78,568Denominator for diluted income
(loss) per share
    
    
    17,336,679
    
    
    
    17,187,792
    
    
    
    17,354,906
    
    
    
    17,182,245Basic earnings (loss) per share
    
    $
    .04
    
    
    $
    (.11
    )
    
    $
    .06
    
    
    $
    (.16
    )Diluted earnings (loss) per share
    
    $
    .04
    
    
    $
    (.11
    )
    
    $
    .06
    
    
    $
    (.16
    )
 For the three months and six months ended June 30, 2006 outstanding options to purchase 2,484,200
and 2,256,850 shares 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 June 30, 2005, options to
purchase 2,922,162 shares of common stock were not included in the calculations of diluted net loss
per share as the effect thereof would be antidilutive.
 -12-




---



##### Table of Contents



OSTEOTECH,
INC.  and SUBSIDIARIES
Notes to Unaudited Condensed Consolidated Financial Statements  (dollars in thousands, except per share data)
 9.
    
    Operating SegmentsSummarized in the table below is financial information for the Companys reportable segments for
the periods indicated:
 Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2006
    
    2005
    
    2006
    
    2005Revenues:DBM Segment
    
    $
    13,712
    
    
    $
    14,012
    
    
    $
    28,201
    
    
    $
    26,907Base Tissue Segment
    
    
    10,831
    
    
    
    10,985
    
    
    
    20,848
    
    
    
    21,528Other
    
    
    739
    
    
    
    293
    
    
    
    1,313
    
    
    
    703Consolidated
    
    $
    25,282
    
    
    $
    25,290
    
    
    $
    50,362
    
    
    $
    49,138Operating income (loss):DBM Segment
    
    $
    628
    
    
    $
    1,237
    
    
    $
    2,072
    
    
    $
    1,883Base Tissue Segment
    
    
    888
    
    
    
    (3,434
    )
    
    
    31
    
    
    
    (4,911
    )Other
    
    
    (608
    )
    
    
    79
    
    
    
    (884
    )
    
    
    (31
    )Consolidated
    
    $
    908
    
    
    $
    (2,118
    )
    
    $
    1,219
    
    
    $
    (3,059
    )
 One of our clients, the Musculoskeletal Transplant Foundation, accounted for 19% of consolidated
net revenues for each of the three months and six months ended June 30, 2006 and 30% of
consolidated net revenues for each of the three months and six months ended June 30, 2005.
 10.
    
    Other Income (Expense)In March 2006, the Company received $125 related to a contingent consideration payment from the
sale in 2002 of a foreign operation, which is included in other income (expense) in the condensed
consolidated statements of operations.Also included in other income (expense) are gains related to changes in exchange rates on foreign
transactions denominated in US dollars, principally intercompany debt, of $246 and $365 for the
three months and six months ended June 30, 2006, respectively. For the three months and six months
ended June 30, 2005, losses related to changes in exchange rates on foreign transactions
denominated in US dollars, principally intercompany debt, were $636 and $821, respectively.
 -13-




---



##### Table of Contents



Item 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
  FOR THE THREE MONTHS AND SIX MONTHS ENDED JUNE 30, 2006 AND 2005
 Results of Operations
 Critical Accounting Policies and Estimates
  Net Income (Loss)
 Three Months Ended June 30,
    
    Six Months Ended June 30,(dollars in thousands,
    
    
    
    
    
    
    
    
    
    
    
    
    
    Percent
    
    
    
    
    
    
    
    
    
    
    
    
    
    Percentexcept per share amounts)
    
    2006
    
    2005
    
    Change
    
    Change
    
    2006
    
    2005
    
    Change
    
    ChangeNet income (loss)
    
    $
    769
    
    
    $
    (1,878
    )
    
    $
    2,647
    
    
    
    141
    %
    
    $
    1,011
    
    
    $
    (2,709
    )
    
    $
    3,720
    
    
    
    137
    %Earnings (loss) per share:Basic
    
    $
    .04
    
    
    $
    (.11
    )
    
    
    
    
    
    
    
    
    
    $
    .06
    
    
    $
    (.16
    )Diluted
    
    $
    .04
    
    
    $
    (.11
    )
    
    
    
    
    
    
    
    
    
    $
    .06
    
    
    $
    (.16
    )
   -14-




---



##### Table of Contents



Net Revenues
   Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,Percent
    
    
    
    
    
    
    
    
    
    
    
    
    
    Percent(dollars in thousands)
    
    2006
    
    2005
    
    Change
    
    Change
    
    2006
    
    2005
    
    Change
    
    ChangeDBM SegmentDomestic
    
    $
    11,359
    
    
    $
    11,761
    
    
    $
    (402
    )
    
    
    (3
    )%
    
    $
    23,699
    
    
    $
    22,758
    
    
    $
    941
    
    
    
    4
    %International
    
    
    2,353
    
    
    
    2,251
    
    
    
    102
    
    
    
    5
    %
    
    
    4,502
    
    
    
    4,149
    
    
    
    353
    
    
    
    9
    %Total DBM Segment
    
    
    13,712
    
    
    
    14,012
    
    
    
    (300
    )
    
    
    (2
    )%
    
    
    28,201
    
    
    
    26,907
    
    
    
    1,294
    
    
    
    5
    %Base Tissue SegmentDomestic:Client Processing
    
    
    2,277
    
    
    
    3,523
    
    
    
    (1,246
    )
    
    
    (35
    )%
    
    
    4,056
    
    
    
    6,767
    
    
    
    (2,711
    )
    
    
    (40
    )%Traditional Tissue
    
    
    2,906
    
    
    
    1,524
    
    
    
    1,382
    
    
    
    91
    %
    
    
    5,409
    
    
    
    2,883
    
    
    
    2,526
    
    
    
    88
    %Graftech® Bio-implants
    
    
    3,533
    
    
    
    4,727
    
    
    
    (1,194
    )
    
    
    (25
    )%
    
    
    7,531
    
    
    
    9,271
    
    
    
    (1,740
    )
    
    
    (19
    )%8,716
    
    
    
    9,774
    
    
    
    (1,058
    )
    
    
    (11
    )%
    
    
    16,996
    
    
    
    18,921
    
    
    
    (1,925
    )
    
    
    (10
    )%International:Client Processing
    
    
    244
    
    
    
    109
    
    
    
    135
    
    
    
    124
    %
    
    
    385
    
    
    
    247
    
    
    
    138
    
    
    
    56
    %Traditional Tissue
    
    
    1,871
    
    
    
    1,102
    
    
    
    769
    
    
    
    70
    %
    
    
    3,467
    
    
    
    2,360
    
    
    
    1,107
    
    
    
    47
    %2,115
    
    
    
    1,211
    
    
    
    904
    
    
    
    75
    %
    
    
    3,852
    
    
    
    2,607
    
    
    
    1,245
    
    
    
    48
    %Total Base Tissue
Segment
    
    
    10,831
    
    
    
    10,985
    
    
    
    (154
    )
    
    
    (1
    )%
    
    
    20,848
    
    
    
    21,528
    
    
    
    (680
    )
    
    
    (3
    )%Other Product Lines
    
    
    739
    
    
    
    293
    
    
    
    446
    
    
    
    152
    %
    
    
    1,313
    
    
    
    703
    
    
    
    610
    
    
    
    87
    %Net Revenues
    
    $
    25,282
    
    
    $
    25,290
    
    
    $
    (8
    )
    
    
    
    
    
    $
    50,362
    
    
    $
    49,138
    
    
    $
    1,224
    
    
    
    2
    %
 -15-




---



##### Table of Contents



Three Months Ended June 30, 2006
 ® ® ®
 ®
  Six Months Ended June 30, 2006
 ® ® ®
 ®
  -16-




---



##### Table of Contents



Gross Margin
 Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,(dollars in thousands)
    
    2006
    
    2005
    
    2006
    
    2005Gross Profit
    
    $
    12,060
    
    
    $
    10,073
    
    
    $
    23,639
    
    
    $
    20,700Gross Margin
    
    
    48
    %
    
    
    40
    %
    
    
    47
    %
    
    
    42
    %
  Operating Expenses
 Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,Percent
    
    
    
    
    
    
    
    
    
    
    
    
    
    Percent(dollars in thousands)
    
    2006
    
    2005
    
    Change
    
    Change
    
    2006
    
    2005
    
    Change
    
    ChangeMarketing, selling,
general
and administrative
    
    $
    10,009
    
    
    $
    10,967
    
    
    $
    (958
    )
    
    
    (9
    )%
    
    $
    20,105
    
    
    $
    21,573
    
    
    $
    (1,468
    )
    
    
    (7
    )%Research and
development
    
    
    1,143
    
    
    
    1,224
    
    
    
    (81
    )
    
    
    (7
    )%
    
    
    2,315
    
    
    
    2,186
    
    
    
    129
    
    
    
    6
    %Total
    
    $
    11,152
    
    
    $
    12,191
    
    
    $
    (1,039
    )
    
    
    (9
    )%
    
    $
    22,420
    
    
    $
    23,759
    
    
    $
    (1,339
    )
    
    
    (6
    )%
  ®
 -17-




---



##### Table of Contents



Operating Income (Loss)
 Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,Percent
    
    
    
    
    
    
    
    
    
    
    
    
    
    Percent(dollars in thousands)
    
    2006
    
    2005
    
    Change
    
    Change
    
    2006
    
    2005
    
    Change
    
    ChangeDBM Segment
    
    $
    628
    
    
    $
    1,237
    
    
    $
    (609
    )
    
    
    (49
    )%
    
    $
    2,072
    
    
    $
    1,883
    
    
    $
    189
    
    
    
    10
    %Base Tissue Segment
    
    
    888
    
    
    
    (3,434
    )
    
    
    4,322
    
    
    
    126
    %
    
    
    31
    
    
    
    (4,911
    )
    
    
    4,942
    
    
    
    101
    %Other Product Lines
    
    
    (608
    )
    
    
    79
    
    
    
    (687
    )
    
    
    (870
    )%
    
    
    (884
    )
    
    
    (31
    )
    
    
    (853
    )
    
    
    (2752
    )%Operating Income
(loss)
    
    $
    908
    
    
    $
    (2,118
    )
    
    $
    3,026
    
    
    
    143
    %
    
    $
    1,219
    
    
    $
    (3,059
    )
    
    $
    4,278
    
    
    
    140
    %
 ®
  Other Income (Expense)
   -18-




---



##### Table of Contents



Income Tax Provision (Benefit)
   Share-Based Compensation
   Liquidity and Capital Resources
   -19-




---



##### Table of Contents



Recent Accounting Developments
  Contractual Obligations
  Impact of Inflation and Foreign Currency Exchange Fluctuations
  -20-




---



##### Table of Contents



Litigation
   -21-




---



##### Table of Contents



Item 3.
    
    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
  
 Item 4.
    
    CONTROLS AND PROCEDURES
 Evaluation of Disclosure Controls and Procedures
     1.
    
    Late in the first quarter of 2006, we started 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. We have interviewed a number of potential candidates for this
position and continue to actively search for a candidate that meets our qualifications and
expectations. In the interim, we engaged an outside consultant during the first quarter of
2006 to assist, under the supervision of our Executive Vice President and Chief Financial
Officer, with our financial reporting process. This consultant will be retained until we
are successful in the search detailed above. In the first quarter of 2006, we hired an
additional
 -22-




---



##### Table of Contents



senior staff accountant to assist in the preparation of journal entries and
account analyses and reconciliations. In addition, our Executive Vice President and Chief
Financial Officer
assumed additional review and oversight responsibilities related to the financial closing
process.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 have 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 underway a project to review and revise, as appropriate, our worldwide
policies and procedures to provide for an increased level of management oversight and
efficient use of finance and accounting staff. We made a number of changes to our
accounting processes during the second quarter of 2006 to improve the efficient use of our
finance and accounting staff.
  Changes in Internal Control Over Financial Reporting
  -23-




---



##### Table of Contents



PART II. OTHER INFORMATION
 
 Item 1. LEGAL PROCEEDINGS
  
 Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
 (a)
    
    An annual meeting of stockholders of Osteotech, Inc. was held on June 21, 2006.(c)
    
    The matters voted upon at the annual meeting and the results of the voting are set forth
below:
 i)
    
    With respect to the election of Directors of Osteotech, the persons named below were
elected at the annual meeting to serve a term of one year or until the next annual meeting
of stockholders. They constitute the entire board of directors of Osteotech. Each received
the following number of votes:
 Director
    
    For
    
    
    WithheldKenneth P. Fallon, III
    
    
    15,387,896
    
    
    
    300,217Stephen S. Galliker
    
    
    15,329,143
    
    
    
    358,970Sam Owusu-Akyaw
    
    
    15,385,896
    
    
    
    302,217Robert J. Palmisano
    
    
    15,450,871
    
    
    
    237,242Thomas M. Patton
    
    
    15,455,921
    
    
    
    232,192Stephen J. Sogin, Ph.D.
    
    
    15,270,337
    
    
    
    417,776
 On June 21, 2006, Mr. Patton verbally notified the Chairman of the Board of Directors of
Osteotech that he would resign his position as a Director effective July 31, 2006 due to
a potential conflict of interest arising from an investment made by a private equity
group with which Mr. Patton is associated. Mr. Patton provided a written confirmation in
the form of an e-mail confirming his resignation.ii)
    
    With respect to a proposal to ratify the appointment of BDO Seidman, LLP as Osteotechs
independent registered public accounting firm for the year ending December 31, 2006, the
stockholders voted 15,609,129 shares in favor, 56,004 shares against and 22,980 shares
abstained. Broker non-votes were not applicable. This proposal received the vote required
by Delaware General Corporation Law and Osteotechs by-laws for approval (i.e. the
affirmative vote of a majority of the shares of common stock represented in person or by
proxy at the annual meeting and entitled to vote on the proposal).
 
 Item 5. OTHER INFORMATION
 On July 31, 2006, the Compensation Committee of Osteotechs Board of Directors (the Committee)
approved the following forms of agreement for use under Osteotechs 2000 Stock Plan (the Plan):
(i) Restricted Stock Unit Agreement for Employees (the Employee RSU Agreement), (ii) Restricted
Stock Unit Agreement for Independent Directors (the Director RSU
 -24-




---



##### Table of Contents



Agreement), and (iii) Restricted Stock Unit Agreement for Consultants (the Consultant RSU
Agreement).
 The terms of the forms of Restricted Stock Unit Agreement provide for the grant of a number of
restricted stock units, which will be paid out in shares of Osteotech common stock once the
applicable vesting criteria have been met. No shares will be issued unless and until the
participant has made satisfactory arrangements to cover applicable tax withholdings. Restricted
stock units granted pursuant to the forms of Employee RSU Agreement and Consultant RSU Agreement
vest as determined by the Committee and generally require an employee to continue as an employee of
Osteotech and a consultant to continue as a service provider through the relevant vesting date.
Restricted stock units granted pursuant to the form of Director RSU Agreement vest on the one year
anniversary of the date of grant so long as the director continues to be a member of Osteotechs
Board of Directors during the vesting period.
 Restricted stock units represent hypothetical shares of Osteotechs common stock and a restricted
stock unit recipient will not be entitled to any of the rights or benefits generally accorded to
company stockholders until the date the restricted stock units become fully vested.The description of the forms of Restricted Stock Unit Agreement set forth herein does not purport
to be complete and is qualified in its entirety by reference to the full text of the form of
Restricted Stock Unit Agreement for Employees filed as Exhibit 10.66 to this Form 10-Q and
incorporated herein by reference in its entirety, the form of Restricted Stock Unit Agreement for
Independent Directors filed as Exhibit 10.67 to this Form 10-Q and incorporated herein by reference
in its entirety and the form of Restricted Stock Unit Agreement for Consultants filed as Exhibit
10.68 to this Form 10-Q and incorporated herein by reference in its entirety.Effective as of June 21, 2006, the Committee granted restricted stock units to independent
directors of Osteotech pursuant to the Plan as follows:
 Number of Shares ofCommon Stock UnderlyingRestricted Stock UnitName
    
    Title
    
    GrantKenneth P. Fallon III
    
    Chairman of
the Board of Directors
    
    5,000Stephen S. Galliker
    
    Director
    
    5,000Robert J. Palmisano
    
    Director
    
    5,000Thomas M. Patton
    
    Director
    
    5,000Stephen J. Sogin
    
    Director
    
    5,000
 The restricted stock units granted to Osteotechs independent directors were granted pursuant to
the form of Restricted Stock Unit Agreement for Independent Directors. The restricted stock units
will vest on June 21, 2007, the one year anniversary of the date of grant, so long as the Director
continues to be a Director of Osteotech at that time. Due to Mr. Pattons notice of resignation on
June 21, 2006, the date of grant, he will no longer be a Director at the time the restricted stock
units granted to him vest, therefore, the restricted stock units granted to Mr. Patton were
effectively forfeited on the same day.
 -25-




---



##### Table of Contents



Item 6. EXHIBITS
  Exhibit
    
    
    
    PageNumber
    
    Description
    
    Number10.66 *
    
    Form of 2000 Stock Plan Restricted Stock Unit Agreement for Employees
    
    +10.67 *
    
    Form of 2000 Stock Plan Restricted Stock Unit Agreement for Independent Directors
    
    +10.68 *
    
    Form of 2000 Stock Plan Restricted Stock Unit Agreement for Consultants
    
    +10.69 *
    
    The Management Performance Bonus Plan, June 2006
    
    +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
    
    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*
    
    Management contract or compensatory plan or arrangement. -26-




---



##### Table of Contents



SIGNATURES
  Date:  August 4, 2006
    
    Osteotech, Inc.(Registrant)Date:  August 4, 2006
    By:
    /s/ Sam Owusu-AkyawSam Owusu-AkyawPresident and Chief Executive Officer
(Principal Executive Officer)Date:  August 4, 2006
    By:
    /s/ Mark H. BurroughsMark H. BurroughsExecutive Vice President,
Chief Financial Officer
(Principal Financial Officer and
Chief Accounting Officer) -27-