**UNITED
STATES**


**SECURITIES
AND EXCHANGE COMMISSION**


Washington,
D.C. 20549





**FORM
10-Q**





**x QUARTERLY REPORT PURSUANT TO SECTION 13 OR
15(d)**


**OF
THE SECURITIES EXCHANGE ACT OF 1934**





For the
Quarterly Period Ended: **March 31, 2005**





**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: **0-27120**




**Kensey
Nash Corporation**


(Exact
name of registrant as specified in its charter)




**Delaware**
    **36-3316412**(State
      or other jurisdiction
    (IRS
      Employer Identification No.)of
      incorporation or organization)




**Marsh
Creek Corporate Center, 55 East Uwchlan Avenue, Exton, Pennsylvania
19341**


(Address
of principal executive offices and zip code)




Registrant's
telephone number, including area code: **(610) 524-0188**




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





Indicate
by check mark whether the registrant is an accelerated filer (as defined in rule
12b-2 of the Exchange Act ). Yes **x**No
**o**





As of
April 30, 2005, there were 11,372,650 outstanding shares of Common Stock, par
value $.001, of the registrant.











**KENSEY
NASH CORPORATION**


**QUARTER
ENDED MARCH 31, 2005**


****


**INDEX**





**PAGE****PART
      I - FINANCIAL INFORMATION****Item
      1.****Financial
      Statements**Condensed
      Consolidated Balance Sheetsas
      of March 31, 2005 (Unaudited) and June 30, 2004
    3Condensed
      Consolidated Statements of Operationsfor
      the three and nine months ended March 31, 2005and
      2004 (Unaudited)
    4Condensed
      Consolidated Statements of Stockholders’ Equity for thenine
      months ended March 31, 2005 (Unaudited) andfor
      the year ended June 30, 2004
    5Condensed
      Consolidated Statements of Cash Flowsfor
      the nine months ended March 31, 2005 and 2004 (Unaudited)
    6Notes
      to Condensed Consolidated Financial Statements (Unaudited)
    7**Item
      2.****Management's
      Discussion and Analysis of **Financial
      Condition and Results of
    Operations****
    18**Item
      3.****Quantitative
      and Qualitative Disclosures about Market Risk**
    37**Item
      4.****Controls
      and Procedures**
    37**PART
      II - OTHER INFORMATION****Item
      2.****Unregistered
      Sales of Equity Securities and Use of Proceeds**
    38**Item
      6.****Exhibits**
    39**SIGNATURES**
    
    40**EXHIBITS**
    
    41


2





**PART
I - FINANCIAL INFORMATION**





**Item
1.**  **Financial Statements**


**KENSEY
      NASH CORPORATION****CONDENSED
      CONSOLIDATED BALANCE SHEETS****March
      31,****ASSETS**
    
    **2005**
    
    **June
      30,**CURRENT
      ASSETS:
    
    **(Unaudited)**
    
    **2004**Cash
      and cash equivalents
    
    $
    3,527,955
    
    $
    14,615,633Investments
    
    
    42,956,722
    
    
    46,480,854Trade
      receivables, net of allowance for doubtful accounts of
    $36,697and
      $13,590 at March 31, 2005 and June 30, 2004, respectively
    
    
    8,509,781
    
    
    6,005,702Royalties
      receivable
    
    
    5,552,126
    
    
    4,432,692Other
      receivables (including approximately $43,000 and $14,000
atMarch
      31, 2005 and June 30, 2004, respectively, due from employees)
    
    
    948,642
    
    
    511,186Inventory
    
    
    4,916,684
    
    
    3,481,599Deferred
      tax asset, current portion
    
    
    1,734,881
    
    
    2,607,669Prepaid
      expenses and other
    
    
    2,566,341
    
    
    1,418,528Total
      current assets
    
    
    70,713,132
    
    
    79,553,863PROPERTY,
      PLANT AND EQUIPMENT, AT COST:Land
    
    
    3,263,869
    
    
    -Leasehold
      improvements
    
    
    9,816,500
    
    
    9,599,237Machinery,
      furniture and equipment
    
    
    22,407,309
    
    
    18,598,090Construction
      in progress - new facility
    
    
    8,469,329
    
    
    918,442Construction
      in progress
    
    
    1,785,610
    
    
    1,142,349Total
      property, plant and equipment
    
    
    45,742,617
    
    
    30,258,118Accumulated
      depreciation
    
    
    (17,000,042
    )
    
    (14,273,218
    )Net
      property, plant and equipment
    
    
    28,742,575
    
    
    15,984,900OTHER
      ASSETS:Deferred
      tax asset, non-current portion
    
    
    -
    
    
    2,825Acquired
      patents and proprietary rights, net of accumulated amortization
      of$2,229,679
      and $1,685,743 at March 31, 2005 and June 30, 2004, respectively
    
    
    4,716,687
    
    
    2,410,623Goodwill
    
    
    3,284,303
    
    
    3,284,303Total
      other assets
    
    
    8,000,990
    
    
    5,697,751TOTAL
    
    $
    107,456,697
    
    $
    101,236,514**LIABILITIES
      AND STOCKHOLDERS' EQUITY**CURRENT
      LIABILITIES:Accounts
      payable
    
    $
    2,764,427
    
    $
    1,847,127Accrued
      expenses (See Note 3)
    
    
    4,527,712
    
    
    4,636,239Current
      portion of debt
    
    
    -
    
    
    219,147Deferred
      revenue
    
    
    100,240
    
    
    109,773Total
      current liabilities
    
    
    7,392,379
    
    
    6,812,286DEFERRED
      REVENUE, NON-CURRENT
    
    
    385,135
    
    
    -DEFERRED
      TAX LIABILITY, NON-CURRENT
    
    
    676,674
    
    
    -Total
      liabilities
    
    
    8,454,188
    
    
    6,812,286COMMITMENTS
      AND CONTINGENCIESSTOCKHOLDERS'
      EQUITY:Preferred
      stock, $.001 par value, 100,000 shares authorized,no
      shares issued or outstanding at March 31, 2005 and June 30,
      2004
    
    
    -
    
    
    -Common
      stock, $.001 par value, 25,000,000 shares authorized,11,319,191
      and 11,511,806 shares issued and outstanding atMarch
      31, 2005 and June 30, 2004, respectively
    
    
    11,319
    
    
    11,512Capital
      in excess of par value
    
    
    73,320,586
    
    
    78,497,472Retained
      earnings
    
    
    25,780,592
    
    
    16,151,233Accumulated
      other comprehensive loss
    
    
    (109,988
    )
    
    (235,989
    )Total
      stockholders' equity
    
    
    99,002,509
    
    
    94,424,228TOTAL
    
    $
    107,456,697
    
    $
    101,236,514
 See notes
to condensed consolidated financial statements.
  3


**KENSEY
      NASH CORPORATION****CONDENSED
      CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)****Three
      Months Ended**
    
    **Nine
      Months Ended****March
      31,**
    
    **March
      31,****2005**
    
    **2004**
    
    **2005**
    
    **2004**REVENUES:Net
      sales
    
    $
    9,365,150
    
    $
    9,402,745
    
    $
    29,664,812
    
    $
    24,756,449Research
      and development
    
    
    -
    
    
    135,099
    
    
    253,292
    
    
    462,208Royalty
      income
    
    
    5,425,668
    
    
    6,237,616
    
    
    15,170,825
    
    
    16,660,906Total
      revenues
    
    
    14,790,818
    
    
    15,775,460
    
    
    45,088,929
    
    
    41,879,563OPERATING
      COSTS AND EXPENSES:Cost
      of products sold
    
    
    3,856,404
    
    
    4,275,791
    
    
    12,206,764
    
    
    11,155,622Research
      and development
    
    
    3,636,957
    
    
    4,308,411
    
    
    11,755,406
    
    
    12,633,967Selling,
      general and administrative
    
    
    3,101,907
    
    
    2,222,779
    
    
    8,365,363
    
    
    6,255,144Total
      operating costs and expenses
    
    
    10,595,268
    
    
    10,806,981
    
    
    32,327,533
    
    
    30,044,733INCOME
      FROM OPERATIONS
    
    
    4,195,550
    
    
    4,968,479
    
    
    12,761,396
    
    
    11,834,830OTHER
      INCOME/(EXPENSE):Interest
      income
    
    
    319,282
    
    
    270,516
    
    
    932,984
    
    
    851,531Interest
      expense
    
    
    -
    
    
    (15,225
    )
    
    (4,559
    )
    
    (55,825
    )Other
      income (expense)
    
    
    33,791
    
    
    (3,286
    )
    
    66,408
    
    
    2,333Total
      other income - net
    
    
    353,073
    
    
    252,005
    
    
    994,833
    
    
    798,039INCOME
      BEFORE INCOME TAX
    
    
    4,548,623
    
    
    5,220,484
    
    
    13,756,229
    
    
    12,632,869Income
      tax expense
    
    
    (1,364,587
    )
    
    (1,735,092
    )
    
    (4,126,869
    )
    
    (3,870,865
    )NET
      INCOME
    
    $
    3,184,036
    
    $
    3,485,392
    
    $
    9,629,359
    
    $
    8,762,004BASIC
      EARNINGS PER SHARE
    
    $
    0.28
    
    $
    0.31
    
    $
    0.84
    
    $
    0.77DILUTED
      EARNINGS PER SHARE
    
    $
    0.26
    
    $
    0.28
    
    $
    0.79
    
    $
    0.72WEIGHTED
      AVERAGE COMMONSHARES
      OUTSTANDING
    
    
    11,377,587
    
    
    11,402,803
    
    
    11,421,073
    
    
    11,401,459DILUTED
      WEIGHTED AVERAGE COMMONSHARES
      OUTSTANDING
    
    
    12,199,697
    
    
    12,265,534
    
    
    12,218,812
    
    
    12,245,510
 See notes
to condensed consolidated financial statements.
  4
 **KENSEY
      NASH CORPORATION****CONDENSED
      CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY****Capital**
    
    
    
    **Accumulated****in
      Excess**
    
    
    
    **Other****Common
      Stock**
    
    **of
      Par**
    
    **Retained**
    
    **Comprehensive**
    
    **Comprehensive****Shares**
    
    **Amount**
    
    **Value**
    
    **Earnings**
    
    **Loss**
    
    **Income**
    
    **Total**BALANCE,
      JUNE 30, 2003
    
    
    11,366,975
    
    $
    11,367
    
    $
    76,356,345
    
    $
    3,200,450
    
    $
    (18,374
    )
    
    
    
    $
    79,549,788Exercise
      of stock options
    
    
    285,331
    
    
    286
    
    
    3,386,148
    
    
    
    
    
    
    
    
    
    
    
    3,386,434Stock
      repurchase
    
    
    (140,500
    )
    
    (141
    )
    
    (2,998,133
    )
    
    
    
    
    
    
    
    
    
    
    (2,998,274
    )Tax
      benefit from exercise of stock options
    
    
    
    
    
    
    
    
    1,708,479
    
    
    
    
    
    
    
    
    
    
    
    1,708,479Stock
      options granted to non-employee
    
    
    
    
    
    
    
    
    11,378
    
    
    
    
    
    
    
    
    
    
    
    11,378Employee
      stock-based compensation
    
    
    
    
    
    
    
    
    33,255
    
    
    
    
    
    
    
    
    
    
    
    33,255Net
      income
    
    
    
    
    
    
    
    
    
    
    
    12,950,783
    
    
    
    
    $
    12,950,783
    
    
    12,950,783Foreign
      currency translation adjustment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    68,569
    
    
    68,569
    
    
    68,569Change
      in unrealized loss on investments (net of tax)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (286,184
    )
    
    (286,184
    )
    
    (286,184
    )Comprehensive
      income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    12,733,168BALANCE,
      JUNE 30, 2004
    
    
    11,511,806
    
    $
    11,512
    
    $
    78,497,472
    
    $
    16,151,233
    
    $
    (235,989
    )
    
    
    
    $
    94,424,228Exercise
      of stock options
    
    
    61,651
    
    
    62
    
    
    782,132
    
    
    
    
    
    
    
    
    
    
    
    782,194Stock
      repurchase (See Note 6)
    
    
    (264,000
    )
    
    (264
    )
    
    (6,872,439
    )
    
    
    
    
    
    
    
    
    
    
    (6,872,703
    )Tax
      benefit from exercise of stock options
    
    
    
    
    
    
    
    
    405,268
    
    
    
    
    
    
    
    
    
    
    
    405,268Employee
      stock-based compensation
    
    
    9,734
    
    
    9
    
    
    508,153
    
    
    
    
    
    
    
    
    
    
    
    508,162Net
      income
    
    
    
    
    
    
    
    
    
    
    
    9,629,359
    
    
    
    
    $
    9,629,359
    
    
    9,629,359Foreign
      currency translation adjustment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    56,707
    
    
    56,707
    
    
    56,707Change
      in unrealized gain on investments (net of tax)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    69,294
    
    
    69,294
    
    
    69,294Comprehensive
      income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    9,755,360BALANCE,
      MARCH 31, 2005 (Unaudited)
    
    
    11,319,191
    
    $
    11,319
    
    $
    73,320,586
    
    $
    25,780,592
    
    $
    (109,988
    )
    
    
    
    $
    99,002,509
 See notes
to condensed consolidated financial statements.
  5





**KENSEY
      NASH CORPORATION****CONDENSED
      CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)****Nine
      Months Ended****March
      31,****2005**
    
    **2004**OPERATING
      ACTIVITIES:Net
      income
    
    $
    9,629,359
    
    $
    8,762,004Adjustments
      to reconcile net income to net cash provided byoperating
      activities:Depreciation
      and amortization
    
    
    4,118,373
    
    
    3,120,679Employee
      stock-based compensation (See Note 9)
    
    
    508,162
    
    
    -Tax
      benefit from exercise of stock options
    
    
    405,268
    
    
    501,668Changes
      in assets and liabilities which (used) provided cash:Accounts
      receivable
    
    
    (4,014,371
    )
    
    (1,820,413
    )Deferred
      tax asset
    
    
    875,613
    
    
    2,487,344Prepaid
      expenses and other current assets
    
    
    (1,201,888
    )
    
    799,014Inventory
    
    
    (1,435,085
    )
    
    (970,315
    )Accounts
      payable and accrued expenses
    
    
    (779,051
    )
    
    182,176Deferred
      revenue
    
    
    (9,533
    )
    
    (58,931
    )Deferred
      tax liability, non-current
    
    
    676,674
    
    
    189,142Deferred
      revenue, non-current
    
    
    385,135
    
    
    -Net
      cash provided by operating activities
    
    
    9,158,656
    
    
    13,192,368INVESTING
      ACTIVITIES:Purchase
      of land for new facility
    
    
    (3,263,869
    )
    
    -Additions
      to property, plant and equipment
    
    
    (4,666,664
    )
    
    (4,502,646
    )Additions
      to new facility construction in progress
    
    
    (5,976,210
    )
    
    -Purchase
      of proprietary rights
    
    
    (2,850,000
    )
    
    -Sale
      of investments
    
    
    22,330,000
    
    
    11,280,000Purchase
      of investments
    
    
    (19,525,569
    )
    
    (20,756,396
    )Net
      cash used in investing activities
    
    
    (13,952,312
    )
    
    (13,979,042
    )FINANCING
      ACTIVITIES:Repayments
      of long term debt
    
    
    (219,147
    )
    
    (621,876
    )Stock
      repurchase
    
    
    (6,872,703
    )
    
    (2,998,274
    )Proceeds
      from exercise of stock options
    
    
    782,194
    
    
    1,524,205Net
      cash used in financing activities
    
    
    (6,309,656
    )
    
    (2,095,945
    )EFFECT
      OF EXCHANGE RATE ON CASH
    
    
    15,634
    
    
    15,410DECREASE
      IN CASH AND CASH EQUIVALENTS
    
    
    (11,087,678
    )
    
    (2,867,209
    )CASH
      AND CASH EQUIVALENTS, BEGINNING OF PERIOD
    
    
    14,615,633
    
    
    15,040,857CASH
      AND CASH EQUIVALENTS, END OF PERIOD
    
    $
    3,527,955
    
    $
    12,173,648SUPPLEMENTAL
      DISCLOSURE OF CASH FLOW INFORMATION:Cash
      paid for interest
    
    $
    4,559
    
    $
    55,825Cash
      paid for income taxes
    
    $
    3,771,567
    
    $
    210,332SUPPLEMENTAL
      DISCLOSURE OF NONCASH FINANCING ACTIVITY:Increase
      in prepaid expense related tonon-employee
      stock options (See Note 5)
    
    $
    -
    
    $
    11,378







See notes
to condensed consolidated financial statements.


****


6


****


****KENSEY
NASH CORPORATION**Notes to Condensed Consolidated Financial
Statements**


**(Unaudited)**


***Note
1 — Condensed Consolidated Financial Statements***




***Principles
of Consolidation and Basis of Presentation***




The
condensed consolidated balance sheet as of March 31, 2005, condensed
consolidated statements of operations for the three and nine months ended March
31, 2005 and 2004, condensed consolidated statement of stockholders’ equity for
the nine months ended March 31, 2005 and condensed consolidated statements of
cash flows for the nine months ended March 31, 2005 and 2004 of Kensey Nash
Corporation (the Company) have not been audited by the Company’s independent
auditors. In the opinion of management, all adjustments (which include only
normal recurring adjustments) necessary to present fairly the financial position
at March 31, 2005 and June 30, 2004, results of operations for the three and
nine months ended March 31, 2005 and 2004, stockholders’ equity for the nine
months ended March 31, 2005 and for the year ended June 30, 2004 and cash flows
for the nine months ended March 31, 2005 and 2004 have been made.





The
consolidated financial statements include the accounts of Kensey Nash
Corporation, Kensey Nash Holding Company and Kensey Nash Europe GmbH. All
intercompany transactions and balances have been eliminated. The Company was
incorporated in Delaware on August 6, 1984. Kensey Nash Holding Company,
incorporated in Delaware in January 1992, was formed to hold title to certain
Company patents and has no operations. Kensey Nash Europe GmbH, incorporated in
Germany in January 2002, was formed for the purpose of European sales and
marketing of the TriActiv ® Embolic
Protection System
(the TriActiv System), which was commercially launched in Europe in May 2002.





Certain
information and footnote disclosures normally included in the Company’s annual
financial statements, prepared in accordance with accounting principles
generally accepted in the United States of America, have been condensed or
omitted. These condensed consolidated financial statements should be read in
conjunction with the financial statements and notes thereto included in the
Company’s consolidated financial statements filed with the Securities and
Exchange Commission (SEC) in the Company’s Annual Report on Form 10-K for the
fiscal year ended June 30, 2004. The results of operations for the three and
nine month periods ended March 31, 2005 are not necessarily indicative of
operating results for the full year.





The
preparation of the consolidated financial statements in conformity with
accounting principles generally accepted in the United States of America
necessarily requires management to make estimates and assumptions. These
estimates and assumptions, which may differ from actual results, will affect the
reported amounts of assets and liabilities and disclosure of contingent assets
and liabilities at the dates of the financial statements, as well as the
reported amounts of revenue and expense during the periods
presented.





***Cash,
Cash Equivalents and Investments***


Cash and
cash equivalents represent cash in banks and short-term investments having an
original maturity of less than three months. Investments
at March 31, 2005 consisted primarily of high quality municipal and U.S.
government and corporate obligations. In accordance with Statement of Financial
Accounting Standards (SFAS) No. 115, *Accounting
for Certain Investments in Debt and Equity Securities* (SFAS
115) *,* the
Company has classified its entire investment portfolio as available-for-sale
marketable securities with secondary or resale markets. The Company’s entire
investment portfolio is reported at fair value with unrealized gains and losses
included in stockholders’ equity (see Comprehensive Income) and realized gains
and losses in other income/(expenses).




7





In March
2004, the FASB ratified the Emerging Issues Task Force (EITF) Issue 03-1, *The
Meaning of Other-Than-Temporary Impairment and Its Application to Certain
Investments* (EITF
03-1). EITF 03-1 requires certain quantitative and qualitative disclosures for
securities accounted for under SFAS 115, *Accounting
for Certain Investments in Debt and Equity Securities* , that
are impaired at the balance sheet date but for which an other-than-temporary
impairment has not been recognized. The disclosure requirements under EITF 03-1
were effective for fiscal years ending after December 15, 2003 and the
recognition and measurement requirements are effective for periods beginning
after June 15, 2004. The Company has included the required disclosures in these
financial statements. On September 30, 2004, the FASB issued FASB Staff Position
(FSP) EITF Issue 03-1-1, which delayed the effective dates indefinitely of
paragraphs 10-20 of EITF 03-1, paragraphs providing guidance on how to evaluate
and recognize an impairment loss that is other than temporary. The Company’s
adoption of the recognition and measurement requirements of EITF 03-1 did not
have a material impact on the Company’s financial position or results of
operations.





The
following is a summary of available-for-sale securities at March 31, 2005 and
June 30, 2004:




**Nine
      Months Ended March 31, 2005****Amortized**
    
    **Gross
      Unrealized**
    
    **Estimated****Description**
    
    **Cost**
    
    **Gain**
    
    **Loss**
    
    **Fair
      Value**Municipal
      Obligations
    
    $
    34,368,104
    
    $
    14,764
    
    $
    (222,555
    )
    $
    34,160,313U.S.
      Government Agency Obligations
    
    
    5,950,500
    
    
    -
    
    
    (3,720
    )
    
    5,946,780U.S.
      Corporate Obligations
    
    
    3,049,308
    
    
    
    
    
    (199,679
    )
    
    2,849,629Total
      Investments
    
    $
    43,367,912
    
    $
    14,764
    
    $
    (425,954
    )
    $
    42,956,722****
    
    
    **Year
      Ended June 30, 2004******
    
    
    **Amortized**
    
    
    **Gross
      Unrealized**
    
    
    **Estimated****Description**
    
    
    **Cost**
    
    
    **Gain**
    
    
    **Loss**
    
    
    **Fair
      Value**Municipal
      Obligations
    
    $
    42,249,426
    
    $
    21,641
    
    $
    (391,248
    )
    $
    41,879,819U.S.
      Government Agency Obligations
    
    
    2,326,608
    
    
    -
    
    
    (145,210
    )
    
    2,181,398U.S.
      Corporate Obligations
    
    
    2,421,000
    
    
    8,190
    
    
    (9,553
    )
    
    2,419,637Total
      Investments
    
    $
    46,997,034
    
    $
    29,831
    
    $
    (546,011
    )
    $
    46,480,854


The
majority of the above investments have maturities ranging from approximately 1
to 5 years. In addition, the Company has one security with a maturity of
approximately 11 years. Also, there are certain municipal variable-rate demand
obligations that have maturities ranging from 5 to 31 years. These municipal
variable-rate demand obligations are putable weekly and callable on a monthly
basis.




The
investment securities shown below currently have fair values less than amortized
cost and therefore contain unrealized losses. The Company has evaluated these
securities and has determined that the decline in value is not related to any
company or industry specific event. At March 31, 2005, there were approximately
33 out of 40 investment securities with unrealized losses. The Company
anticipates full recovery of amortized costs with respect to these securities at
maturity or sooner in the event of a more favorable market interest rate
environment. The lengths of time the securities have been in a continuous
unrealized loss position, aggregated by investment by category, at March 31,
2005 were as follows:




8





**Description**
    
    **Loss
      < 12 months**
    
    **Loss
      > 12 months**
    
    **Total****Gross**
    
    
    
    **Gross**
    
    
    
    **Gross****Estimated**
    
    **unrealized**
    
    **Estimated**
    
    **unrealized**
    
    **Estimated**
    
    **unrealized****Fair
      Value**
    
    **losses**
    
    **Fair
      Value**
    
    **losses**
    
    **Fair
      Value**
    
    **losses**Municipal
      Obligations
    
    $
    14,080,942
    
    $
    (129,139
    )
    $
    4,259,911
    
    $
    (93,416
    )
    $
    18,340,853
    
    $
    (222,555
    )U.S.
      Government Agency Obligations
    
    
    5,946,780
    
    
    (3,720
    )
    
    -
    
    
    -
    
    
    5,946,780
    
    
    (3,720
    )U.S.
      Corporate Obligations
    
    
    497,975
    
    
    (2,025
    )
    
    2,351,654
    
    
    (197,654
    )
    
    2,849,629
    
    
    (199,679
    )Total
      Investments
    
    $
    20,525,697
    
    $
    (134,884
    )
    $
    6,611,565
    
    $
    (291,070
    )
    $
    27,137,262
    
    $
    (425,954
    )
 ******


***Export
Sales***


There
were $234,189 and $518,305 in export sales from the Company’s U.S. operations to
unaffiliated customers in Europe and Asia in the three and nine months ended
March 31, 2005, respectively. Export sales for the three and nine months ended
March 31, 2004 were $120,823 and $338,507, respectively.





***Revenue
Recognition***





**Sales
Revenue**


The
Company recognizes revenue under the provisions of Staff Accounting Bulletin
(SAB) No. 101, *Revenue
Recognition*  *in
Financial Statements* (SAB
101). ** Accordingly,
sales revenue is recognized when the related product is shipped. All product is
shipped freight-on-board shipping point. Advance payments received for products
or services are recorded as deferred revenue and are recognized when the product
is shipped or services are performed. The Company reduces sales revenue for
estimated customer returns and other allowances, including discounts. The
Company manufactures medical products specifically to customer specifications
for the majority of its customers, which are subject to return only for failure
to meet customer specifications. The Company had sales returns allowances and
discounts of $2,360 and $109,305 for the three and nine months ended March 31,
2005, respectively. In the three and nine months ended March 31, 2004, there
were sales returns allowances and discounts of $91,079 and $73,487,
respectively.




**Research
and Development Revenue**


Revenue
under research and development contracts is recognized as the related expenses
are incurred. All revenues recorded on this line item are derived from
government programs under which the U.S. government funds the research of high
risk, enabling technologies. The program reflected in the statement of
operations for fiscal 2004 and the nine months ended March 31, 2005 is an award
for the research of a synthetic vascular graft, which concluded in September
2004. Also included in fiscal 2004 statements of operations is an award for the
research of breast cancer drug delivery technology, which concluded in October
2003.





**Royalty
Income**


The
Company recognizes substantially all of its royalty revenue at the end of each
month, in accordance with its agreements with St. Jude Medical and Orthovita,
when the Company is advised by the respective party of the net total end-user
product sales dollars for the month. Royalty payments from both parties are
generally received within 45 days of the end of each calendar quarter.





The
Company receives a 6% royalty on every Angio-Seal unit sold by St. Jude Medical,
its licensee. The final
contracted decrease in the royalty rate, from 9% to 6%, occurred in April 2004
when four million cumulative units had been sold. As of March 31, 2005
approximately 5.5 million Angio-Seal units had been sold.




The
Company receives a royalty on all co-developed VITOSS FOAM product sales by
Orthovita. The royalty is pursuant to an agreement entered into between the
Company and Orthovita in March 2003. The first royalty was earned in February
2004 when the first co-developed product was commercially launched by Orthovita.
In addition, in a separate transaction, the Company acquired proprietary rights
of a third party to the VITOSS technology. This acquisition entitled the Company
to certain rights, including the economic rights, of the third party. These
economic rights included a royalty on all products containing the VITOSS
technology. The first royalty under this transaction was earned for the quarter
ended September 30, 2004, when the transaction was completed.




9





***Earnings
Per Share***


Earnings
per share are calculated in accordance with SFAS No. 128, *Earnings
per Share (SFAS 128),* which
requires the Company to report both basic and diluted earnings per share (EPS).
Basic and diluted EPS are computed using the weighted average number of shares
of Common Stock outstanding, with common equivalent shares from options included
in the diluted computation when their effect is dilutive. Options to purchase
shares of our Common Stock which were outstanding for the three and nine months
ended March 31, 2005 and 2004, but were not included in the computation of
diluted EPS because the exercise prices of the options exceeds the average
market price and would have been antidilutive are shown in the table
below:


**Three
      Months Ended**
    
    **Nine
      Months Ended****March
      31,**
    
    **March
      31,****2005**
    
    **2004**
    
    **2005**
    
    **2004**Number
      of Options
    
    
    259,911
    
    
    1,500
    
    
    226,431
    
    
    1,489Option
      Price Range
    
    $
    31.60
      - $34.36
    
    $
    25.55
    
    $
    30.03
      - $34.36
    
    $
    25.55


******


***Stock-Based
Compensation***


Stock-based
compensation cost is accounted for under SFAS No. 123, *Accounting
for Stock-Based Compensation* (SFAS
123), ** which
currently permits (i) recognition of the fair value of stock-based awards as an
expense, or (ii) continued application of the intrinsic value method of
Accounting Principles Board Opinion No. 25, *Accounting
for Stock Issued to Employees* (APB 25).
The Company accounts for its stock-based employee and director compensation
plans under the recognition and measurement principles of APB 25. Under this
intrinsic value method, compensation cost represents the excess, if any, of the
quoted market price of the Company’s Common Stock at the grant date over the
amount the grantee must pay for the stock.





The
Company’s policy is to grant employee stock options with an exercise price equal
to the fair market value of the Company’s Common Stock at the date of grant,
therefore recording no compensation expense under APB 25. Options granted to
non-employee outside consultants, as defined under SFAS 123 (R), are recorded as
compensation expense based on the fair market value of such grants. All
restricted shares granted to Executive Officers and to non-employee members of
the Board of Directors are recorded as compensation expense using the intrinsic
value method under APB 25. See Note 5 for a discussion of options granted to
non-employee outside consultants in July 2003 and October 2002. See Note 9 for
restricted stock awards granted to the non-employee members of the Board of
Directors and to executive officers of the Company.





In
December 2002, the FASB issued SFAS No. 148, *Accounting
for Stock-Based Compensation - Transition and Disclosure - an amendment to FASB
Statement No. 123, Accounting for Stock-Based Compensation* (SFAS
148). The Company implemented the “disclosure only” provisions of SFAS 148 in
the period ended December 31, 2002, thereby recording no compensation cost for
stock options issued to employees under the Company’s two stock option plans.
Had compensation costs for the plans been determined based on the fair market
value of the stock options and the restricted stock, consistent with the
provisions of SFAS 123 as amended by SFAS 148, the Company’s net income and
earnings per share for the three and nine months ended March 31, 2005 and 2004
would have been reduced to the pro forma amounts below:





10
 
  **Three
      Months Ended**
    
    **Nine
      Months Ended****March
      31,**
    
    **March
      31,****2005**
    
    **2004**
    
    **2005**
    
    **2004**Net
      income, as reported
    
    $
    3,184,036
    
    $
    3,485,392
    
    $
    9,629,359
    
    $
    8,762,004**Add
      back fair market value expense:**Non-employee
      option grants(1)
    
    
    14,140
    
    
    13,938
    
    
    42,420
    
    
    41,814**Add
      back intrinsic value expense:**Restricted
      stock grants(2)
    
    
    133,327
    
    
    —
    
    
    462,816
    
    
    —**Deduct
      fair market value expense:**Non-employee
      option grants(1)
    
    
    (14,140
    )
    
    (13,938
    )
    
    (42,420
    )
    
    (41,814
    )Restricted
      stock grants(3)
    
    
    (133,327
    )
    
    —
    
    
    (462,816
    )
    
    —-Employee
      stock options(3)
    
    
    (692,642
    )
    
    (343,382
    )
    
    (1,990,474
    )
    
    (1,025,275
    )Pro
      forma net income
    
    $
    2,491,394
    
    $
    3,142,010
    
    $
    7,638,885
    
    $
    7,736,729Earnings
      per share:Basic
      - as reported
    
    $
    0.28
    
    $
    0.31
    
    $
    0.84
    
    $
    0.77Basic
      - pro forma
    
    $
    0.22
    
    $
    0.28
    
    $
    0.67
    
    $
    0.68Diluted
      - as reported
    
    $
    0.26
    
    $
    0.28
    
    $
    0.79
    
    $
    0.72Diluted
      - pro forma
    
    $
    0.20
    
    $
    0.26
    
    $
    0.62
    
    $
    0.63
  (1)
      Amounts represent compensation expense determined under the fair market
      value method included in reported net income, net of related tax
      effect.(2)
      Amounts represent compensation expense determined under the intrinsic
      value method included in reported net income, net of related tax
      effects.(3)
      Amounts represent compensation expense if it had been determined under
      fair market value based method for all awards, net of related tax
      effects.


On
December 16, 2004, the FASB finalized SFAS No. 123 (R) *Share-Based
Payment* (SFAS
123(R)), which will be effective for annual reporting periods beginning after
June 15, 2005. The new standard will require the Company to begin expensing
stock options during the quarter ended September 30, 2005. The FASB has
expressed the view that the use of a binomial lattice model for option valuation
is capable of more fully reflecting certain characteristics of employee share
options than other approved valuation models. The Company currently uses the
Black-Scholes valuation model but has begun a process to analyze how the
utilization of a binomial lattice model could impact the valuation of its
options.





***Comprehensive
Income***


The
Company accounts for comprehensive income under the provisions of SFAS No. 130, *Reporting
Comprehensive Income* (SFAS
130). Accordingly, accumulated other comprehensive income (loss) is shown in the
consolidated statements of stockholders’ equity at March 31, 2005 and June 30,
2004, and is comprised of net unrealized gains and losses on the Company’s
available-for-sale securities and foreign currency translation adjustments. The
tax (expense) benefit of other comprehensive income for the nine months ended
March 31, 2005 and for the fiscal year ended June 30, 2004 was $(35,697) and
$147,428, respectively.





11


******


***Goodwill***


Goodwill
represents the excess of cost over the fair market value of the identifiable net
assets of THM Biomedical, Inc. (THM), a company acquired in September 2000. The
Company accounts for goodwill under the provisions of SFAS No. 141, *Business
Combinations* (SFAS
141) and SFAS No. 142, *Goodwill
and Other Intangible Assets* (SFAS
142). SFAS 141 requires that the purchase method of accounting be used for all
business combinations subsequent to June 30, 2001 and specifies criteria for
recognizing intangible assets acquired in a business combination. Under SFAS
142, goodwill and intangible assets with indefinite useful lives are no longer
amortized, but are subject to annual impairment tests. Intangible assets with
definite useful lives continue to be amortized over their respective useful
lives.




There
were no changes to the net carrying amount of goodwill at March 31, 2005 from
June 30, 2004. The Company completed its initial required goodwill impairment
test under SFAS 142 in the first quarter of fiscal 2002. The most recent tests
in fiscal 2004, 2003 and 2002 indicated that goodwill was not
impaired.





***Patents
and Proprietary Rights***


T he costs
of internally developed patents are expensed when incurred due to the long
development cycle for patents and the Company’s inability to measure the
recoverability of these costs when incurred.




In
November 1997, the Company entered into an agreement (the Patent Acquisition
Agreement) to acquire a portfolio of puncture closure patents and patent
applications as well as the rights of the seller under a pre-existing licensing
agreement. In addition, in September 2000 in conjunction with the acquisition of
THM, the Company acquired a separate portfolio of patents related to its
biomaterials business.




The costs
of the Patent Acquisition Agreement and patents acquired as part of the THM
acquisition are being amortized over the remaining periods of economic benefit,
ranging from 4 to 9 years at March 31, 2005. The gross carrying amount of such
patents at March 31, 2005 was $4,096,366 with accumulated amortization of
$1,883,013. Amortization expense on these patents was $65,757 and $197,269 for
the three and nine-month periods ended March 31, 2005, respectively and included
within research and development expense for such periods. Amortization expense
on the Company’s acquired patents is estimated at $263,026 for each of the years
ending June 30, 2005, 2006, 2007, 2008 and 2009.




In August
2004, the Company acquired the intellectual property rights of a third party, an
inventor of the VITOSS technology (the Inventor), for $2,600,000 under an
assignment agreement with the Inventor (the Assignment Agreement). Under the
Assignment Agreement, the Company receives all intellectual property rights of
the Inventor that had not previously been assigned to Orthovita. Also under the
Assignment Agreement, the Company receives a royalty from Orthovita on the sale
of all Orthovita products containing the VITOSS technology, up to a total
royalty to be received of $4,035,782. As of March 31, 2005, the Company
recognized royalty income of $464,163 under the Assignment Agreement and
$3,571,619 was yet to be received. The entire cost of these proprietary rights
is being amortized over the 60-month period the Company anticipates to receive
the economic benefit in relation to the proprietary rights. Amortization expense
on these proprietary rights was $130,000 and $346,667 for the three and nine
months ended March 31, 2005, respectively, and included within selling, general
and administrative expense for such periods. Amortization expense on these
proprietary rights is estimated at $476,667 for the year ending June 30, 2005
and $520,000 for each of the years ending June 30, 2006 through
2009.





In March
2005, the Company entered into an agreement to acquire patents and other
proprietary rights from a pair of inventors (the Technology Purchase Agreement).
The intellectual property and processing information acquired under the
Technology Purchase Agreement is complimentary to and broadens our existing
biomaterials intellectual property and materials processing knowledge platform.
Under the Technology Purchase Agreement, the Company paid $250,000 for the
patents upon execution of the agreement and is obligated to pay certain
milestone payments and royalties upon achievement of certain product development
and commercial launch goals for products that incorporate the acquired patent
technology. The Company anticipates that the patents and other proprietary
rights acquired will enhance its existing biomaterials platform and have
alternative future uses to expand such platform. The initial $250,000 purchase
price of the patents will be amortized over the
remaining period of economic benefit of such patents, currently estimated at
approximately 16 years at March 31, 2005. The gross carrying amount of the
acquired technology at March 31, 2005 was $250,000. Amortization expense on the
acquired technology will be $5,348 for the fiscal year ending June 30, 2005 and
will be included within research and development expense. Amortization expense
on the acquired technology is currently estimated at $16,043 for each of the
fiscal years ending June 30, 2006, 2007, 2008, 2009 and 2010.





12


******


***New
Accounting Pronouncements***


In
December 2003, the FASB issued SFAS No. 132 (revised 2003), *Employers’
Disclosures about Pensions and Other Postretirement Benefits - an amendment of
FASB Statements No. 87, 88, and 106* (SFAS 132
revised), which improves financial statement disclosures for defined benefit
plans. The change replaces existing FASB disclosure requirements for pensions
and requires additional disclosures about the assets, obligations, cash flows,
and net periodic benefit cost of defined benefit pension plans and other defined
benefit postretirement plans. The guidance was effective for fiscal years ending
after December 15, 2003, and for the first fiscal quarter of the year following
initial application of the annual disclosure requirements. The Company’s
adoption of SFAS 132 revised provides enhanced disclosures of 401(k) matching
contributions but has no impact on the Company’s financial position or results
of operations.





In
November 2004, the FASB issued SFAS No. 151, *Inventory
Costs* (SFAS
151). SFAS 151 amends the accounting for abnormal amounts of idle facility
expense, freight, handling costs, and wasted material (spoilage) under the
guidance in ARB No. 43, Chapter 4, *Inventory
Pricing* .
Paragraph 5 of ARB No. 43, Chapter 4, previously stated “ . . . *under
some circumstances, items such as idle facility expense, excessive spoilage,
double freight, and rehandling costs may be so abnormal as to require treatment
as current period charges* . . .."
SFAS 151 requires that those items be recognized as current-period charges
regardless of whether they meet the criterion of " *so
abnormal* ." In
addition, SFAS 151 requires that allocation of fixed production overheads to the
costs of conversion be based on the normal capacity of the production
facilities. This statement is effective for inventory costs incurred during
fiscal years beginning after June 15, 2005. Management does not expect adoption
of SFAS 151 to have a material impact on the Company's financial
position or results of operations.





In
December 2004, the FASB issued SFAS No. 153, *Exchanges
of Nonmonetary Assets* (SFAS
153), an amendment to Opinion No. 29, *Accounting
for Nonmonetary Transactions* . SFAS
153 eliminates certain differences in the guidance in Opinion No. 29 as compared
to the guidance contained in standards issued by the International Accounting
Standards Board. The amendment to Opinion No. 29 eliminates the fair value
exception for nonmonetary exchanges of similar productive assets and replaces it
with a general exception for exchanges of nonmonetary assets that do not have
commercial substance. Such an exchange has commercial substance if the future
cash flows of the entity are expected to change significantly as a result of the
exchange. SFAS 153 is effective for nonmonetary asset exchanges occurring in
periods beginning after June 15, 2005. Earlier application is permitted for
nonmonetary asset exchanges occurring in periods beginning after December 16,
2004. Management does not expect adoption of SFAS 153 to have a material impact
on the Company's financial
position or results of operations.





In
December 2004, the FASB issued SFAS 123(R). SFAS 123(R) amends SFAS 123 and APB
25. SFAS 123(R) requires that the cost of share-based payment transactions
(including those with employees and non-employees) be recognized in the
financial statements. SFAS 123(R) applies to all share-based payment
transactions in which an entity acquires goods or services by issuing (or
offering to issue) its shares, share options, or other equity instruments
(except for those held by an ESOP) or by incurring liabilities (1) in amounts
based (even in part) on the price of the entity's shares or other equity
instruments, or (2) that require (or may require) settlement by the issuance of
an entity's shares or other equity instruments. This statement is effective for
the Company as of the first annual reporting period beginning after June 15,
2005. The new
standard will require the Company to begin expensing stock options during the
quarter ending September 30, 2005. Management
is currently assessing the effect of SFAS 123(R) on the Company's financial
position and results of operations. To date the Company has expensed all
share-based payments to non-employees and all restricted shares granted. The
effect of the statement will relate only to the Company’s expensing of stock
options.





13


******


***Note
2 — Inventory***




Inventory
is stated at the lower of cost (determined by the average cost method, which
approximates first-in, first-out) or market. Inventory primarily includes the
cost of material utilized in the processing of the Company’s products and is as
follows:


**March
      31,**
    
    **June
      30,****2005**
    
    **2004**Raw
      materials
    
    $
    3,659,532
    
    $
    2,449,180Work
      in process
    
    
    942,780
    
    
    603,069Finished
      goods
    
    
    485,349
    
    
    472,565Gross
      inventory
    
    
    5,087,661
    
    
    3,524,814Provision
      for inventory obsolescence
    
    
    (170,977
    )
    
    (43,215
    )Inventory
    
    $
    4,916,684
    
    $
    3,481,599


Adjustments
to inventory are made at the individual part level for estimated excess,
obsolescence or impaired balances, to reflect inventory at the lower of cost or
market. Factors influencing these adjustments include: changes in demand, rapid
technological changes, product life cycle and development plans, component cost
trends, product pricing, physical deterioration and quality concerns. Revisions
to these adjustments would be required if any of these factors differ from the
Company’s estimates.




***Note
3 — Accrued Expenses***




As of
March 31, 2005 and June 30, 2004, accrued expenses consisted of the
following:




**March
      31,**
    
    **June
      30,****2005**
    
    **2004**Accrued
      payroll and related compensation
    
    $
    1,840,078
    
    $
    1,852,078Current
      tax liability
    
    
    310,322
    
    
    1,873,195Accrued
      new facility costs
    
    
    1,574,678
    
    
    —Other
    
    
    802,634
    
    
    910,966Total
    
    $
    4,527,712
    
    $
    4,636,239
 ******
 14
 ******
 ***Note
4 — Debt***




On
September 1, 2000, in conjunction with the acquisition of THM Biomedical, the
Company incurred a note payable in the amount of $4.5 million (the Acquisition
Obligation). The Acquisition Obligation was due in equal quarterly installments.
As of September 30, 2004, the Company had repaid the entire Acquisition
Obligation and had no remaining debt.





***Note
5 — Consulting Contracts***





In
October 2002, the Company granted options to purchase 50,000 shares of common
stock to a physician pursuant to a five-year consulting agreement related to the
development of a carotid artery application for the TriActiv
System .





In July
2003, the Company granted options to purchase 1,500 shares of common stock to a
physician pursuant to a two-year consulting agreement related to the development
of orthopaedic applications for the Company’s porous and non-porous tissue
fixation and regeneration devices and drug delivery devices.





The
Company calculated the fair value of these non-employee options, in accordance
with SFAS 123, as $375,550 and $11,378 for the October 2002 and July 2003
grants, respectively, using the Black-Scholes option-pricing model. These
amounts were recorded as prepaid consulting expense and increases to additional
paid in capital in the quarters ended December 31, 2002 and September 30, 2003,
respectively. The prepaid expense is being amortized to research and development
expense over the terms of the agreements. Accordingly, $20,200 and $60,600 were
recorded as a component of research and development expense for the three and
nine months ended March 31, 2005 and 2004, respectively.





***Note
6 — Stock Repurchase Program***





On August
17, 2004, the Company announced that its board of directors had reinstated a
program to repurchase issued and outstanding shares of the Company’s Common
Stock over six months from the date of the board reinstatement. The reinstated
plan called for the repurchase of up to 259,000 shares, the balance under the
original plan approved in October 2003. In the nine months ended March 31, 2005,
the Company repurchased
and retired 199,867 shares of common stock under the reinstated program at a
cost of approximately $5.1 million, or an average market price of $25.72 per
share. This
program expired in February 2005.





On March
16, 2005, the Company announced a new stock repurchase program under which an
additional 400,000 shares issued and outstanding shares of the Company’s Common
Stock were approved by the board of directors. This plan expires on September
30, 2005. As with the first stock repurchase program, the Company plans to
continue to repurchase its shares for cash, from time to time in the open
market, through block trades or otherwise. The repurchase program does not
require the Company to purchase any specific dollar value or number of shares.
Any further purchases under the program will depend on market conditions and may
be commenced or suspended at any time or from time to time without prior notice.
As of March 31, 2005, the Company has repurchased and retired 64,133 shares of
Common Stock under this new program at a cost of approximately $1.7 million, or
an average market price of $27.00 per share, using available cash. At March 31,
2005, there were 335,867 shares remaining for repurchase under this
program.





The
following table contains information about the Company’s purchases of its equity
securities during January, February, and March 2005:




15


**Total
      number of**
    
    **Maximum
      Number****Average
      Price**
    
    **Shares
      Purchased**
    
    **of
      Shares that May****Total
      Number of**
    
    **Paid
      per**
    
    **as
      Part of a Publicly**
    
    **Yet
      Be Purchased****Period**
    
    **Shares
      Purchased**
    
    **Share**
    
    **Announced
      Program**
    
    **Under
      the Program**January
      1-31, 2005
    
    
    -
    
    **$**
    **-**
    
    
    **-**
    
    
    **-**February
      1-28, 2005
    
    
    **-**
    
    
    **-**
    
    
    **-**
    
    
    **-**March
      1-31, 2005
    
    
    64,133
    
    
    27.00
    
    
    64,133
    
    
    335,867Total
    
    
    64,133
    
    $
    27.00
    
    
    64,133
    
    
    335,867


***Note
7 — Income Taxes***





As of
June 30, 2004, the Company had net operating loss (NOL) carryforwards for state
tax purposes totaling $20.0 million, which will expire by the end of its fiscal
year 2024. In addition, the Company had a foreign NOL of $300,000 at June 30,
2004, which will not expire.





During
the fourth quarter of fiscal 2003, the Company performed a retrospective
research and development tax credit study for fiscal years 1993 through 2003.
The Company recorded the majority of the tax credit resulting from this study
($1.5 million) in the fourth quarter of fiscal 2003. During the first quarter of
fiscal 2004, the Company recorded an additional portion of the research and
development tax credit ($310,000) and professional service fees as a component
of selling, general and administrative expenses ($50,500) related to this
research and development tax credit study.





***Note
8 — Retirement Plan***





The
Company has a 401(k) Salary Reduction Plan and Trust (the 401(k) Plan) in which
all employees that are at least 21 years of age are eligible to participate.
Contributions to the 401(k) Plan are made by employees through an employee
salary reduction election. Effective October 1, 1999, the Company implemented a
25% discretionary matching contribution, on up to 6% of an employee’s total
compensation, for all employee contributions. Effective July 1, 2004, the
Company revised its discretionary matching contribution to 50%, on up to 6% of
an employee’s total compensation, for all employee contributions. Employer
contributions to the 401(k) plan for the three and nine months ended March 31,
2005 were $96,208 and $256,128, respectively. In the three and nine months ended
March 31, 2004, employer contributions were $35,553 and $101,971,
respectively.





***Note
9 — Restricted Stock***





The
Company may provide restricted stock grants under its Employee Incentive
Compensation Plan approved by the Company’s stockholders. During fiscal years
2004 and 2005, the Company granted shares of restricted Common Stock to the
non-employee members of the Board of Directors and to executive officers of the
Company. The shares granted to non-employee members of the Board of Directors
vest in three equal annual installments contingent upon the Company’s
achievement of certain earnings per share targets, Company Common Stock price
targets and continued service of the board member on each anniversary of the
date of grant. The shares granted to executive officers vest in three equal
annual installments based solely on continued employment with the Company.
Unvested shares are forfeited upon termination of service on the Board of
Directors or employment, as applicable. The Company made the following grants to
non-employee, directors and executive officers during nine months ended March
31, 2005 and the fiscal year ended June 30, 2004:





16




**Nine
      Months Ended**
    
    **Fiscal
      Year Ended****March
      31,**
    
    **June
      30,****2005**
    
    **2004**Shares
      granted:Non-employee
      Directors
    
    
    12,000
    
    
    11,580Executive
      officers
    
    
    55,500
    
    
    -Total
      shares granted
    
    
    67,500
    
    
    11,580Intrinsic
      value on the date of grant
    
    $
    1,915,060
    
    $
    253,950




The
intrinsic value disclosed above is based upon the closing price of the Company’s
common stock on the date of grant.





Compensation
expense related to all restricted stock grants is being recorded over the
three-year vesting period of these grants. Compensation expense related to the
Board of Directors shares is recorded as a component of selling, general and
administrative expense. Compensation expense related to executive officer shares
is recorded as a component of either selling, general and administrative or
research and development expense, dependent on the executive officer receiving
the shares. For the three and nine months ended March 31, 2005 the Company
recognized expense of $190,467 and $661,167, respectively, related to restricted
stock awards.





***Note
10 — Opportunity Grant***





In
November 2004, the Company was awarded a $500,000 grant under the Opportunity
Grant Program of the Department of Community and Economic Development of the
Commonwealth of Pennsylvania. This grant was awarded to the Company for the
potential job-creating economic development opportunities created by the
Company’s construction of its new facility within the state of Pennsylvania. The
grant is conditioned upon meeting the following: (1) the Company will create 238
full-time jobs within 5 years, beginning April 1, 2003, the date of the
Company’s request for the grant, (2) the Company will invest at least
$54,250,000 in total project costs, including, but not limited to, personnel,
land and building construction within three years, beginning July 19, 2004, the
date of the Company’s facility groundbreaking and (3) the Company will operate
at its new facility for a minimum of 5 years. The Company received the cash
payment of $500,000 in its third fiscal quarter 2005. Revenue will be recognized
as earned over the longest period contained within the grant commitment term
(five years from the date of occupancy of the Company’s new facility). This date
of satisfaction of the last grant commitment is expected to be in December 2010,
assuming the current expectation for a transition to the new facility in January
2006. As of March 31, 2005, approximately $34,000 of revenue was recognized
related to this grant as a component of Other Income. Revenue
from this opportunity grant is estimated at $54,054 for the year ending June 30,
2005 and $81,081 for each of the years ending June 30, 2006 through 2009 and
thereafter.


******


17


******


***Item
2.***  ***Management's
Discussion and Analysis of Financial Condition and Results of
Operations***




The
following discussion and analysis should be read in conjunction with our
consolidated financial statements and the related notes included in this report
and our audited consolidated financial statements and the related notes
contained in our Annual Report on Form 10-K for the fiscal year ended June 30,
2004, as filed with the Securities and Exchange Commission.





***Overview***





Kensey
Nash Corporation is a leading medical technology company providing innovative
solutions, via novel technologies, for a wide range of medical procedures. We
have expanded our business model extensively over the last ten years, from an
original focus on vascular puncture closure, to our current model where we
provide an extensive range of products to multiple medical markets, primarily
cardiovascular, sports medicine and spine, amongst others. We invented the
Angio-SealTM Vascular Closure Device (the Angio-Seal), a device designed to seal
and close femoral artery punctures made during diagnostic and therapeutic
cardiovascular catheterizations. As pioneers in the field of absorbable
biomaterials, we have developed significant experience, expertise and
competitive advantage in the design, development, manufacture and processing of
absorbable biomaterials for medical applications. Our most recent advance into
the cardiovascular market is the TriActiv â Embolic
Protection System (the TriActiv System), a device designed to provide embolic
protection during the treatment of diseased vessels.





Our
initial success is rooted in the Angio-Seal device, of which we were the
original designer, developer and manufacturer, since product launch over five
and a half million devices have been sold in the marketplace. St. Jude Medical
(St. Jude Medical) acquired the worldwide license to the Angio-Seal device in
March of 1999. The Angio-Seal device was commercialized in the U.S. in 1996 and
is currently the worldwide leader in the vascular closure device market. St.
Jude Medical develops and manufactures the product as well as markets and
distributes the product worldwide. We currently receive a 6% royalty on every
Angio-Seal device sold to the end-user and also sell to St. Jude Medical the
collagen plug and anchor components of the Angio-Seal device. We are a secondary
source for the anchor component, which is primarily manufactured by St. Jude
Medical. As specified in our contract with St. Jude Medical, in April 2004 when
the four millionth Angio-Seal unit had been sold, the final unit royalty rate
reduction from 9% to 6% occurred.





We have
utilized the knowledge gained during the development process of the absorbable
biomaterials components of the Angio-Seal device, the anchor and the collagen
plug, as a catalyst into the application of absorbable biomaterials into
multiple medical markets. Our extensive experience with these biomaterials has
enabled us to develop expertise in the design, development, manufacture and
processing of proprietary biomaterials products which we now apply to the fields
of orthopaedics (including sports medicine and spine), cardiology,
drug/biologics delivery, periodontal, general surgery and wound care. We have
several strategic partnerships and alliances through which our biomaterials
products are developed and marketed. We intend to continue to leverage our
proprietary knowledge and expertise in each of these markets to develop new
products and technologies and to explore additional applications for our
existing products.





The
TriActiv System is a device designed to provide embolic protection during the
treatment of diseased vessels, with an initial application in diseased saphenous
vein grafts (SVGs). The TriActiv System is a balloon embolic protection device
in a market populated or pursued by both balloon and filter devices. While both
approaches have advantages and disadvantages, the TriActiv System has a unique
design, offering three key features: an embolic protection balloon, a flush
catheter and a controlled extraction system. We believe the combination of these
features offers the most complete and effective solution to embolic protection.
On July 28, 2004, we submitted a 510(k) application to the United States Food
and Drug Administration (FDA) and in March 2005, we received FDA clearance,
allowing us to market and sell the TriActiv System in the United States. We
launched the device utilizing a newly formed direct sales force and sold our
first device to the end user in April 2005. The TriActiv System is also
commercially available for sale in Europe. Future generations of the TriActiv
System, currently in development and in clinical trials, will be designed to
address additional markets. These future applications will potentially include
the treatment of diseased carotid, peripheral and native coronary arteries as
well as acute myocardial infarction (AMI) (a heart attack) and the removal of
thrombus during such treatments.





18





In order
to accommodate our growth, we are constructing a new facility and expect to
transition operations to such facility in our third quarter of fiscal 2006 (see
Liquidity and Capital Resources). During the remainder of fiscal 2005 and
through fiscal 2006, we expect significant non-cash charges related to the
acceleration of depreciation on the leasehold improvements in our current leased
facility. In addition, we anticipate cash expenses for our moving costs into the
new facility. We are currently evaluating the impact of the transition on the
remainder of our fiscal 2005 and 2006 financial statements.





*Revenues* . Our
revenues consist of three components: net sales, research and development
revenue and royalty income.





*Net
Sales* . Net
sales are comprised of sales of absorbable biomaterials products and the
TriActiv System.





*Biomaterials.*The
      biomaterials component of net sales, which comprises 99% of total net
      sales, represents the sale of our biomaterials products to customers for
      use in the following markets: orthopaedics (sports medicine and spine),
      cardiology, drug/biologics delivery, periodontal, general surgery and
      wound care. The two most significant components of our biomaterials sales
      are the absorbable components of the Angio-Seal device, supplied to St.
      Jude Medical, and our orthopaedic product sales. Our orthopaedic product
      sales to date have consisted primarily of sales to Arthrex, Inc. (Arthrex)
      and Orthovita, Inc. (Orthovita). Arthrex is a privately-held orthopaedics
      company for which we manufacture a wide array of sports medicine products.
      Orthovita is a publicly-held orthopaedic biomaterials company for which we
      co-developed and manufacture bone graft substitute products used primarily
      in spine procedures. Below is a table showing the trends in our Angio-Seal
      component sales and orthopaedic product sales as a percentage of our total
      biomaterial sales:




**Nine
      months ended****Sales
      of:**
    **March
      31, 2005**
    
    **March
      31, 2004**Angio-Seal
      Components
    39%
    
    39%Orthopaedic
      Products
    56%
    
    58%


Sales
      ofthe Angio-Seal components as a percentage of our total biomaterials sales
      remained consistent from the first nine months of fiscal 2004 to the first
      nine months of fiscal 2005. The sales of the collagen plug component
      increased 39% to $9.1 million dollars for the nine months ended March 31,
      2005 as compared to $6.6 million in the nine months ended March 31, 2004.
      The absorbable polymer anchor component decreased 18% to $2.4 million for
      the nine months ended March 31, 2005 as compared to $2.9 million in the
      nine months ended March 31, 2004. This decline is the result of the
      ongoing transition of the manufacture of the absorbable polymer anchor to
      St. Jude Medical. Based on discussions with St. Jude Medical, we believe
      their current plans are for us to remain a secondary supplier of future
      anchor requirements. We continue to supply a minimum of 50% of the
      collagen component for the device under a three-year contract with St.
      Jude Medical, which currently expires in December 2005.****The
      two companies are currently negotiating a renewal of the existing
      contract. In addition to renewing the St. Jude contract, the future of
      this portion of our biomaterials sales is dependent upon the continued
      success of the Angio-Seal device in the vascular closure market. Today we
      estimate that the Angio-Seal device has approximately 60% of this market
      based on end-user sales of over $80 million in the quarter ended March 31,
      2005. The Angio-Seal market share may be impacted by future competition in
      this market or new technologies to address diagnostic or therapeutic
      treatment of diseased coronary arteries.





19




Orthopaedic
      sales increased 16% to $16.5 million from $14.2 million for the nine
      months ended March 31, 2005 and 2004, respectively. The increase in our
      orthopaedic products sales was primarily related to sales ofbone
      graft substitute productsto
      Orthovita which began in the third quarter of fiscal 2004 and totaled $1.4
      million dollars in the third quarter fiscal 2005 and $6.1 million dollars
      in the first nine months of fiscal 2005. Due to the greater medical
      community acceptance, we have been able to expand our biomaterials
      customer and product base by initiating new partnerships within the
      medical device industry, as well as expanding the product lines for our
      current customers. The growth of the orthopaedic portion of our business
      is dependent on several factors, including the success of our current
      partners in sports medicine and spine, the continued acceptance of
      biomaterials-based products in these two markets as well as expanded
      future acceptance, and our ability to offer new products or technologies
      and attract new partners in these markets. We are regularly evaluating our
      current technologies and potential new technologies on which to base new
      avenues of growth into the biomaterials product
markets.
 
 *TriActiv.*The
      TriActiv System is a platform technology, offering not only our initial
      application for the protection from embolization during treatment of
      diseased saphenous vein grafts, but also future applications for the
      treatment of carotid artery disease and the removal of thrombus, amongst
      others. Embolic protection is a relatively new technology and is still
      subject to acceptance by the medical community, particularly for future
      applications. In addition, because we are selling the device in the U.S.
      ourselves, competing against products marketed by other large, experienced
      medical device sales teams, we must develop a successful sales strategy
      that will differentiate the TriActiv System from other competing
      products.
 
 In
      the U.S., we launched the TriActiv System after receiving FDA clearance in
      March 2005, through our newly formed direct sales force. This direct sales
      team currently consists of 17 members including 11 sales representatives,
      3 members of senior management, and three clinical sales support personnel
      around the country. We will continue to build this sales team as required
      to address the demands for the product and service existing
      accounts.
 
 In
      Europe, the TriActiv System was commercially launched in May 2002. We are
      selling direct in Germany and via distributors throughout the rest of
      Europe. We have distributor agreements for sales in Ireland, Switzerland,
      Austria, Italy, Netherlands, and the United Kingdom. In addition, in April
      2005 we initiated a distribution agreement in India, our first agreement
      in Asia. We are in the process of identifying distributors for additional
      markets in Europe and Asia. The TriActiv System sales were less than 1% of
      our total sales for each of the three and nine months ended March 31, 2005
      and 2004. We anticipate sales of the TriActiv System will become a more
      significant component of net sales during the remainder of our fiscal year
      2005 and through fiscal 2006 and beyond as we increase our sales of the
      product in the U.S. market, gain new customers in the European and Asian
      markets and introduce new versions and applications of the product in both
      the U.S and Europe. We originally received European Community approval (CE
      Mark) to market the second-generation of the TriActiv System, the
      TriActivâFXTM Embolic Protection System (the TriActiv FX System), in fiscal 2004.
      This second generation device incorporates several important ease-of-use
      design enhancements including an integrated, fully disposable flush and
      extraction system, a new balloon inflator that simplifies catheter
      exchanges during the procedure, and a monorail flush catheter to enhance
      device usage and reduce procedure time. We have since made additional
      changes to the TriActiv FX System, which required a new dossier submission
      to the European Union. We received CE Mark approval on the new TriActiv FX
      System in March 2005. A European launch of the TriActiv FX System occurred
      during the final week of our third fiscal quarter of fiscal
      2005.


20


**


*Research
and Development Revenue.* Research
and development revenue was derived from a National Institute of Standards and
Technology (NIST) grant in the nine months ended March 31, 2005. No research and
development revenue was generated in the three months ended March 31, 2005.
Research and development revenue was derived from the NIST grant in the three
months ended March 31, 2004 and from both the NIST grant and the National
Institute of Health (NIH) grant in the nine months ended March 31, 2004. In
October 2001 we received the NIST grant, a $1.9 million grant over a three-year
period, under which we were researching a synthetic vascular graft, utilizing
our Porous Tissue Matrix (the PTMTM) technology. We continue to develop this
technology, however this grant funding concluded in September 2004 and we will
receive no additional funding for this grant. In January 2003, we received from
NIH a $100,000 grant over a one-year period, under which we were researching
sustained or controlled release of chemotherapeutic drugs for the treatment of
breast cancer utilizing our PTM technology. This grant was completed in October
2003, but we are continuing to independently develop this drug delivery
technology.





*Royalty
Income.* Our
royalty income primarily consists of royalties received from St. Jude Medical
and Orthovita. Royalties from St. Jude Medical are received on every Angio-Seal
unit sold worldwide. We anticipate sales of the Angio-Seal device will grow
approximately 15 to 20% in fiscal 2006, with forecasted continued procedure
growth and as St. Jude Medical continues to expand its sales and marketing
efforts and launch new generations of the product. Our royalty rate as of March
31, 2004 was 9%. Under our License Agreement with St. Jude Medical, there was a
final contractual decrease in the royalty rate, to 6%, upon reaching four
million cumulative units sold. This final rate reduction occurred in April 2004.
We currently believe continued Angio-Seal unit growth will partially offset this
33% decline in royalty rate resulting in a net reduction in royalty income in
fiscal 2005 from fiscal 2004 of approximately 9%. We expect that royalty income
from the Angio-Seal device will continue to be a significant source of revenue
for the foreseeable future. As of March 31, 2005, approximately 5.5 million
Angio-Seal units had been sold.





In March
2003, we entered into an agreement with Orthovita under which we are
co-developing and commercializing products based on Orthovita’s proprietary,
ultra porous VITOSS bone void filler material in combination with our
proprietary biomaterials. The products have applications in the bone grafting
and spinal surgery markets. Under the agreement, the products are co-developed,
we manufacture the products and Orthovita markets and sells the products
worldwide. In addition to sales revenue from the VITOSS products sold to
Orthovita, we also receive a royalty on Orthovita’s end-user sales of all
co-developed products.





In August
2004, in order to enhance the overall business relationship with Orthovita, we
acquired the proprietary rights of a third party, an inventor of the VITOSS
technology (the Inventor), for $2.6 million under an assignment agreement with
the Inventor (the Assignment Agreement). Under the Assignment Agreement, the
Company receives an additional royalty from Orthovita on the end-user sales of
all Orthovita products containing the VITOSS technology up to a total royalty to
be received of $4,035,782, with $3,571,619 remaining at March 31, 2005.





Orthovita
launched its initial bone grafting and spinal product lines, VITOSS scaffold
FOAM strips and cylinders, in the third quarter of fiscal 2004. A third family
of products, VITOSS scaffold FOAM flow was launched in June 2004 and a fourth
family of products VITOSS scaffold FOAM shapes was launched in September 2004.
We believe the unique technology associated with the VITOSS FOAM products and
the growing spine market will result in the Orthovita component of our royalty
income becoming more significant over the next several quarters and beyond.





*Cost
of Products Sold.* Our gross
margin on sales increased in the three
and nine months ended March 31, 2005 as compared to the three and nine months
ended March 31, 2004. We continue to experience high volumes of our sales of
biomaterials products and are
achieving greater manufacturing efficiencies, which has lowered our unit costs
in many of our product lines. We anticipate the gross margin on our biomaterials
products will remain at or increase from this level with increases in sales
volume and efficiencies gained in new product lines. These gross margins could
potentially be offset by initial margins on the TriActiv product line in the
last quarter of fiscal 2005, our first quarter of commercial production for the
U.S. market. The lower margins on TriActiv will affect the first several
quarters of production until the manufacturing processes mature and volumes
grow. The effect should be minimal in our fourth fiscal quarter 2005, as sales
of the TriActiv product are not expected to increase significantly until the
first quarter of fiscal 2006. We anticipate a 58% to 60% gross margin on sales
for fiscal 2005, a range which is heavily dependent on the product mix.





21


**


*Research
and Development Expenses.* Research
and development expense consists of expenses incurred for the development of our
proprietary technologies, such as the TriActiv System, absorbable and
nonabsorbable biomaterials products and technologies and other development
programs, including expenses under the NIST program. In December 2001, we began
our TriActiv System U.S. pivotal clinical study, the PRIDE study, a randomized
trial at sites in the U.S and Europe. We completed enrollment in the PRIDE study
during March 2004. We enrolled a total of 894 patients in the study, including
roll-in patients, at 68 sites in the U.S. and 10 sites in Europe. On July 28,
2004, we submitted a 510(k) application for FDA clearance to market the TriActiv
System in the United States and in March 2005 received such clearance.





We
submitted our Investigational Device Exemption (IDE) to the FDA to begin a U.S.
clinical trial registry, the ASPIRE ( A ngioplasty
in S VGs with P ost I ntervention R emoval of E mbolic
Debris) Clinical Study, on the next generation TriActiv System, the TriActiv FX
System. The ASPIRE study began in our third quarter of fiscal 2005 and is
expected to be completed by our second quarter of fiscal 2006. ASPIRE is a
multi-center, prospective registry, designed to support regulatory clearance of
the TriActiv FX System in the U.S. for a saphenous vein graft (SVG) indication.
The study will include approximately 100 to 120 patients at up to 30 sites in
the U.S and Europe. We cannot make any assurances as to the successful
completion of this trial or regulatory approval for the TriActiv FX System or
for future applications in the U.S. or in Europe.





Clinical
efforts in pursuit of FDA approval and continuing development of the TriActiv
System, as well as our continued development of proprietary biomaterials
products and technologies, require significant research and development
expenditures. We anticipate research and development expense, including
additional clinical trials, will increase as we pursue commercialization of
future generations of the TriActiv System in the U.S., and explore opportunities
for other indications related to the TriActiv System, as well as our other
technologies, including the continued development of proprietary biomaterials
technologies. While we believe research and development expenditures will
increase in dollars, we believe that they will decrease as a percentage of total
revenue as our revenue grows. Research and development expense was 26% of total
revenues for the nine months ended March 31, 2005 compared to 30% of total
revenue for the nine months ended March 31, 2004.





*Selling,
General and Administrative.* Selling,
general and administrative expenses include the costs of our finance,
information technologies, human resource and business development departments,
as well as costs related to the sales and marketing of our products. The general
and administrative component has increased over the same period in fiscal 2004.
This increase is a result of the overall growth of our business and the
administrative requirements to support such growth, such as personnel expenses
and expenses incurred related to compliance with new SEC and corporate
governance regulations. In addition, due to the growth in our business,
including increasing manufacturing volumes of both biomaterials products and the
TriActiv System and the new requirements of selling the TriActiv System directly
to the market, we implemented a new Enterprise Resource Planning (ERP) system to
replace our existing Materials Requirements Planning (MRP) system. In October
2004, we started the ERP implementation, which integrates our manufacturing,
quality, finance and human resource processes into a single information system
so our operational areas can share information more easily and efficiently.
Implementation was completed March, 2005. In addition, amortization expense of
$347,000 related to the Assignment Agreement (discussed above) is included as a
general and administrative expense in the nine months ended March 31, 2005. The
amortization period is estimated at 60 months from the date of the agreement.





22





The sales
and marketing component of selling, general and administrative consists of
expenses in the U.S. and in Europe related to the direct commercialization
efforts for the TriActiv System in both cases. We have a seventeen person
TriActiv sales and marketing team in the U.S. and an eight person sales and
marketing team headquartered at our European subsidiary, Kensey Nash Europe
GmbH. These teams are selling the product direct in the U.S. and German markets
and, in Europe, the team supports our distributor relationships outside of
Germany in the rest of Europe and Asia.





Our sales
and marketing expenses have increased in the nine months ended March 31, 2005
over the same period in fiscal 2004. This increase related to increased efforts
related to the launch of the TriActiv System in the U.S. including the addition
of the direct sales force. We anticipate sales and marketing expenses will
increase as we continue our sales and marketing efforts of the TriActiv product,
both in the U.S. and in Europe. Our sales and marketing expenses are expected to
increase $2.0 million to $2.5 million, including personnel and marketing
expenses related to our the TriActiv System launch, in fiscal 2005 over fiscal
2004. We also continue to expand our marketing efforts for our biomaterials
business.





*Income
Tax Expense.* We
estimate that our effective tax rate for the fiscal 2005 will be approximately
30%, which includes estimates of our current year research
and development tax credit as well as non-taxable interest income.





**Critical
Accounting Policies**





Our
“critical accounting policies” are those that require application of
management’s most difficult, subjective or complex judgments, often as a result
of the need to make estimates about matters that are inherently uncertain and
may change in future periods. It is not intended to be a comprehensive list of
all of our significant accounting policies. In many cases, the accounting
treatment of a particular transaction is specifically dictated by generally
accepted accounting principles, with no need for management’s judgment in their
application. There are also areas in which the selection of an available
alternative policy would not produce a materially different result. We have
identified the following as our critical accounting policies: revenue
recognition, accounting for stock-based compensation, allowance for doubtful
accounts, inventory valuation and income taxes.





*Revenue
Recognition.* We
recognize revenue under the provisions of Staff Accounting Bulletin (SAB) No.
101, *Revenue
Recognition in Financial Statements* (SAB
101). On December 18, 2003, the SEC issued SAB No. 104, *Revenue
Recognition* (SAB 104), which supersedes SAB 101. 
SAB 104’s primary purpose is to rescind accounting
guidance contained in SAB 101 related to multiple element
revenue arrangements, which was superseded as a result of the issuance
of Emerging Issues Task Force (EITF) Issue 00-21, *Accounting
for Revenue Arrangements with Multiple Deliverables* (EITF
00-21). The adoption of SAB 104 did not have a material impact
the Company’s financial position or results of
operations.





*Sales
Revenue.* Sales
revenue is recognized when the related product is shipped. Advance payments
received for products or services are recorded as deferred revenue and are
recognized when the product is shipped or services are performed. All of our
shipments are Free on Board (F.O.B.) shipping point. We reduce sales for
estimated customer returns, discounts and other allowances, if applicable. The
majority of our products are manufactured according to our customers’
specifications and are subject to return only for failure to meet those
specifications.





*Research
and Development Revenue.* Revenue
under research and development contracts is recognized as the related expenses
are incurred. All revenues recorded on this line item are related to government
programs under which the U.S. government funds the research of high risk,
enabling technologies.





23


**


*Royalty
Revenue.* Royalty
revenue is recognized as the related product is sold. We recognize substantially
all of our royalty revenue at the end of each month, in accordance with our
customer agreements. (See Note 1 to the Condensed Consolidated Financial
Statements - Revenue Recognition).




*Accounting
for Stock-Based Compensation.* We
account for stock-based compensation costs under Statement of Financial
Accounting Standards (SFAS) No. 123, *Accounting
for Stock-Based Compensation* (SFAS
123), as amended by SFAS No. 148, *Accounting
for Stock-Based Compensation - Transition and Disclosure - an amendment to FASB
Statement No. 123, Accounting for Stock-Based Compensation* (SFAS
148), which permits (i) recognition of the fair value of stock-based awards as
an expense, or (ii) continued application of the intrinsic value method of
Accounting Principles Board (APB) Opinion No. 25, *Accounting
for Stock Issued to Employees* (APB
25). We account for our stock-based employee and director compensation plans
under the recognition and measurement principles of APB 25. Under this intrinsic
value method, compensation cost represents the excess, if any, of the quoted
market price of our common stock at the grant date over the amount the grantee
must pay for the stock. Our policy is to grant stock options at the fair market
value at the date of grant. Therefore, we have not recognized any compensation
expense for options granted to employees. Options granted to non-employees, as
defined under SFAS 123, (as amended by SFAS 148) and EITF 96-18, *Accounting
for Equity Instruments that are Issued to Other Than Employees for Acquiring or
in Conjunction with Selling, Goods or Services* , are
recorded as compensation expense over the contractual service period using the
fair market value method in accordance with SFAS 123, which requires using the
Black-Scholes option pricing model to determine the fair market value of the
option at the original grant date. We granted options to non-employee, outside
consultants during fiscal 2003 and 2004. See Note 5 to the financial statements
for information regarding options granted to non-employee outside consultants in
July 2003 and October 2002. We account for restricted shares to non-employee
members of the Board of Directors and executive officers using the intrinsic
value method in accordance with APB 25. We granted restricted shares to members
of the Board of Directors and executive officers during fiscal 2004 and 2005.
See Note 9 to the Condensed Consolidated Financial Statements for restricted
stock awards made to the non-employee members of the Board of Directors and to
executive officers of the Company.





In
December 2004, the FASB issued SFAS No. 123(R), *Share-Based
Payment* (SFAS
123(R)). SFAS 123(R) amends SFAS 123 and APB 25. SFAS 123(R) requires that the
cost of share-based payment transactions (including those with employees and
non-employees) be recognized in the financial statements. SFAS 123(R) applies to
all share-based payment transactions in which an entity acquires goods or
services by issuing (or offering to issue) its shares, share options, or other
equity instruments or by incurring liabilities (1) in amounts based (even in
part) on the price of the entity's shares or other equity instruments, or (2)
that require (or may require) settlement by the issuance of an entity's shares
or other equity instruments. This statement is effective for the Company as of
the first interim period beginning after June 15, 2005, the quarter ending
September 30, 2005. Management is currently assessing the effect of SFAS 123(R)
on the Company's financial position or results of operations . To date
the Company has expensed all  share-based
payments to non-employees and all restricted shares granted. The effect of the
statement will relate only to the Company’s expensing of stock options.





*Restricted
Shares* . The
Company has implemented a practice of granting restricted shares to the members
of its Board of Directors as well as to its executive officers, as permitted
under its stock option plans, as a component of Board and executive officer
compensation arrangements. In response to growing industry concerns related to
the effect of expensing stock options, the Company has diversified its
compensation arrangements to reduce the number of total options granted to board
members and executive officers. The compensation arrangements now include the
granting of restricted shares as well as, for executive officers, a greater
component of incentive cash compensation. All compensation expense related to
the Board of Directors is being recorded as a component of selling, general and
administrative expense. All compensation expense related to the executive
officers is currently recorded as a component of either selling, general and
administrative expense or research and development expense, dependent on the
executive officers functional area. The first restricted shares were granted to
the Board of Directors in December 2003 and the first restricted shares to
executive officers were granted in July of 2004.





24


**


*Allowance
for Doubtful Accounts.* Our
allowance for doubtful accounts is determined using a combination of factors to
ensure that our trade receivables balances are not overstated due to
uncollectibility. We maintain a bad debt reserve for all customers based on a
variety of factors, including the length of time receivables are past due,
trends in overall weighted average risk rating of the total portfolio,
significant one-time events and historical experience with each customer. Also,
we record additional reserves for individual accounts when we become aware of a
customer's inability to meet its financial obligations to us, such as in the
case of bankruptcy filings or deterioration in the customer's operating results
or financial position. If circumstances related to specific customers change,
our estimates of the recoverability of receivables would be adjusted. We believe
our allowance at March 31, 2005 was sufficient to cover all existing accounts
receivable.





*Inventory
Valuation.* Our
inventory is stated at the lower of cost or market. Adjustments to inventory are
made at the individual part level for estimated excess, obsolescence or impaired
balances, to reflect inventory at the lower of cost or market. Factors
influencing these adjustments include changes in demand, rapid technological
changes, product life cycle and development plans, component cost trends,
product pricing, physical deterioration and quality concerns. Revisions to these
adjustments would be required if any of these factors differ from our
estimates.





*Income
Taxes.* Our
estimated effective tax rate includes the impact of certain estimated research
and development tax credits and non-taxable interest income . Material
changes in, or differences from, our estimates could impact our estimate of our
effective tax rate.


****


25


****


**Results
of Operations**


****


**Comparison
of Three Months Ended March 31, 2005 and 2004**





The
following table summarizes our operating results for the three months ended
March 31, 2005 compared to the three months ended March 31, 2004.




**Three
      Months Ended**
    **Percent
      Change****($
      millions)**
    **March
      31, 2005**
    ***%
      of TotalRevenues***
    **March
      31,2004**
    ***%
      of TotalRevenues***
    **Prior Period to Current
    Period**REVENUES:Total
      Revenues
    $14.8
    *100%*
    $15.8
    *100%*
    (6%)Net
      Sales
    $9.4
    *63%*
    $9.4
    *60%*
    0%Research
      & Development Revenue
    $
      —
    *0%*
    $0.1
    *1%*
    (100%)Royalty
      Income
    $5.4
    *37%*
    $6.2
    *39%*
    (13%)EXPENSES:Cost
      of Products Sold
    $3.9
    *26%*
    $4.3
    *27%*
    (10%)Research
      & Development Expense
    $3.6
    *25%*
    $4.3
    *27%*
    (16%)Selling,
      General & Administrative Expense
    $3.1
    *21%*
    $2.2
    *14%*
    40%INTEREST
      INCOME
    $0.3
    *2%*
    $0.3
    *2%*
    18%NET
      INCOME
    $3.2
    
    $3.5
    
    (8%)


*Total
Revenues* . Total
revenues decreased 6% to $14.8 million in the three months ended March 31, 2005
from $15.8 million in the three months ended March 31, 2004.





*Net
Sales.* Net sales
of products remained constant at $9.4 million for the three months ended March
31, 2005 and 2004. We had a 22% increase in our cardiology product sales offset
by a 14% decrease in our orthopaedic product sales.





Cardiology
biomaterial sales increased by 22% to $4.1 million from $3.3 million for the
three months ended March 31, 2005 and 2004, respectively. This increase related
to sales of the collagen plug component of the Angio-Seal product to St. Jude
Medical, which increased $1.0 million, or 50% over the prior year comparable
period, offset by a decrease in sales of the polymer anchor component of the
Angio-Seal device, which decreased $432,000, or 37% over the prior year
comparable period. Sales of the polymer anchor were expected to decrease year
over year due to the transition of the manufacture of the absorbable polymer
anchor from us to St. Jude Medical. Based on discussions with St. Jude Medical,
we believe their current plans are for us to remain a secondary supplier of the
future anchor requirements for the Angio-Seal device. We continue to supply the
collagen component of the device under a three-year contract with St. Jude
Medical, which currently expires in December 2005. The two companies are
currently negotiating a renewal of the existing contract. Net sales for the
three months ended March 31, 2005 and March 31, 2004 consisted almost entirely
of biomaterials sales as the TriActiv System sales were less than 1% of total
sales in both periods.





As
mentioned, orthopaedic sales decreased 14% to $4.9 million in the three months
ended March 31, 2005 from $5.7 million for the three months ended March 31,
2004. This decline was primarily the result of an $862,000 decrease in sales of
sports medicine products to Arthrex. Sales to Arthrex were $3.4 million in the
three months ended March 31, 2005, compared to $4.2 million in the same period a
year earlier. This decrease was anticipated and, as previously disclosed by
management, related primarily to inventory planning adjustments by Arthrex.
Sales of our sports medicine products in the fourth quarter of fiscal 2005 are
estimated to remain consistent with the third quarter but to steadily increase
throughout the fiscal 2006. The year over year decrease in sales to Arthrex was
partially offset by an increase of 11%, or $143,000, in sales of VITOSS FOAM
bone graft substrate products to Orthovita totaling $1.4 million in the three
months ended March 31, 2005 up from $1.2 million in the prior year period.





26





*Research
and Development Revenues* . There
were no research and development revenues in the three months ended March 31,
2005, compared to $135,000 of such revenues in the three months ended March 31,
2004. The revenues for the three months ended March 31, 2004 consisted of
amounts generated under our NIST synthetic vascular graft grant. The NIST
synthetic vascular graft grant concluded in September 2004.





*Royalty
Income* . Royalty
income decreased 13% to $5.4 million from $6.2 million in the three months ended
March 31, 2005 and 2003, respectively. This decrease was due to a decline in our
Angio-Seal royalties partially offset by the addition of the Orthovita royalty
in March 2004.





St. Jude
Medical Angio-Seal end-user sales increased 17%, to approximately $80 million
during the three months ended March 31, 2005 compared to approximately $68
million during the three months ended March 31, 2004. In addition to the
increase in the number of units St. Jude Medical sold, another reason for the
increase in Angio-Seal sales was an increase in the average selling price for
the Angio-Seal device which increased year over year, partially due to favorable
currency exchange rates on sales in Europe. These increases were offset by the
33% contracted royalty rate decline from 9% to 6%, which occurred in April 2004.
As a result, Angio Seal royalties decreased 21% from $6.2 million to $4.9
million in the third quarters of fiscal 2004 and 2005, respectively.





Partially
offsetting the Angio-Seal royalty income decrease were royalties from Orthovita
under the March 2003 manufacturing, development and supply agreement between our
two companies. We receive a royalty on all Orthovita end-user sales of
co-developed VITOSS FOAM products. The first royalty was earned in the third
quarter of fiscal 2004 when Orthovita commercially launched the first
co-developed products. Additionally, we acquired separate VITOSS proprietary
rights from a third party inventor of the VITOSS technology. Under this
agreement the Company receives an additional royalty from Orthovita on the
end-user sales of all Orthovita products containing the VITOSS technology. The
first payment was earned in the quarter ended September 30, 2004. (See Note 1 to
the Condensed Consolidated Financial Statements - Patents and Proprietary
Rights). Total royalty income from Orthovita under both agreements was
approximately $572,000 for the third quarter of fiscal 2005.





*Cost
of Products Sold* . Cost of
products sold decreased 10% to $3.9 million in the three months ended March 31,
2005 from $4.3 million in the three months ended March 31, 2004. Gross
margin on sales increased to 59% in the three months ended March 31, 2005
compared to 55% in the three months ended March 31, 2004. The increase in gross
margin reflected manufacturing efficiencies gained as our biomaterials products
mature. Our gross margins could potentially be reduced by initial margins on the
TriActiv product line in the last quarter of fiscal 2005, our first quarter of
commercial production for the U.S. market. The lower margins on TriActiv
products will affect the first several quarters of production until the
manufacturing processes mature and volumes grow. The effect should be minimal in
our fourth quarter of fiscal 2005, as sales of the TriActiv product are not
expected to increase significantly until the first quarter of fiscal 2006. We
anticipate a 58% to 60% gross margin on sales for fiscal 2005, which is heavily
dependent on the product mix of our sales.





27


**


*Research
and Development Expenses* . Research
and development expenses decreased 16% to $3.6 million in the three months
ended March 31, 2005 compared to $4.3 million in the three months ended
March 31, 2004. This decrease related primarily to research and development
expenses on the TriActiv System, specifically for expenses of the PRIDE clinical
trial which concluded in March 2004. The TriActiv System research and
development expenses decreased $674,000, or 25%, to $2.0 million in the three
months ended March 31, 2005 from $2.7 million in the three months ended March
31, 2004. TriActiv System c linical
expenses decreased $963,000 in the third quarter 2005 compared to the comparable
quarter of fiscal 2004. This decrease was offset by operational expenses related
to testing performed on new generations of the TriActiv System which increased
$107,000 in the three months ended March 31, 2005 from the three months ended
March 31, 2004. In addition, there were increases in personnel costs, including
restricted share and incentive compensation expense, of $145,000.





Biomaterials
and other proprietary technologies spending remained consistent at $1.6 million
for the three months ended March 31, 2005 and 2004. We expect research and
development expenses to increase as we investigate and develop new products,
conduct clinical trials and seek regulatory approvals for our proprietary
products.





*Selling,
General and Administrative Expense* .
Selling, general and administrative expense increased 40% to $3.1 million in the
three months ended March 31, 2005 from $2.2 million in the three months ended
March 31, 2004. General and administrative expenses increased $410,000 to $1.5
million in the three months ended March 31, 2005 from $1.1 million in the three
months ended March 31, 2004. The increase was primarily attributable to a
$188,000 increase in legal and professional service fees, specifically audit and
legal fees related to complying with the Sarbanes-Oxley Act of 2002, as well as
restricted share expense for the board of directors. In addition, there was
$130,000 of amortization expense on intellectual proprietary rights acquired in
August 2004.





Sales and
marketing expenses increased $469,000 to $1.6 million from $1.1 million in the
three months ended March 31, 2005 and 2004, respectively. This increase was
primarily the result of our U.S. expenses, which increased $473,000 to $980,000
in the three months ended March 31, 2005 from $507,000 in the three months ended
March 31, 2004. Personnel and travel expenses increased $394,000 relating to the
hiring of the TriActiv System direct sales force and clinical sales support
staff. As of March 31, 2005, we had 9 sales representatives, 3 members of senior
management and one clinical sales support person on the sales team. In addition,
there was an increase of $111,000 in marketing expenses related to product
training for the new sales team as well as marketing materials created for the
launch of the TriActiv System.





The
TriActiv System European sales and marketing costs remained relatively
consistent during the three months ended March 31, 2004 and 2005. Expenses for
the three months ended March 31, 2005 were $585,000 and expenses for the three
months ended March 31, 2004 were $589,000. There was an increase in convention
and marketing expenses, including product samples, of $98,000. These increases
were offset by a decrease of $104,000 related to a clinical study to support
reimbursement of the product in Europe. This study concluded in December 2004.





*Net
Interest Income* .
Interest income increased by 18% to $319,000 in the three months ended March 31,
2005 from $271,000 in the three months ended March 31, 2004. Although our cash
and investments decreased by 14% in the three months ended March 31, 2005 over
the comparable prior year period, the decrease was more than offset by an
increase in interest rates. There was no interest expense in the three months
ended March 31, 2005 compared to $15,000 in the three months ended March 31,
2004. ** As of
September 30, 2004, all debt related to the THM Obligation was paid in full. No
other debt obligations remain.





*Other
Income.* Other
non-operating income was $34,000 in the three months ended March 31, 2005
compared to a loss of $3,300 in the three months ended March 31, 2004. This
increase relates to $33,784 of grant revenue recognized under our opportunity
grant from the Commonwealth of Pennsylvania (See Liquidity and Capital Resources
Section and Note 10).





28




**Comparison
of Nine months ended March 31, 2005 and 2004**





The
following table summarizes our operating results for the nine months ended March
31, 2005 compared to the nine months ended March 31, 2004.




**Nine
      months ended**
    **Percent**
      **Change****($
      millions)**
    **March
      31, 2005**
    ***%
      of Total***
      ***Revenues***
    **March
      31,**
      **2004**
    ***%
      of Total***
      ***Revenues***
    **Prior
      Period to**
      **Current
      Period**REVENUES:Total
      Revenues
    $45.1
    *100%*
    $41.9
    *100%*
    8%Net
      Sales
    $29.7
    *66%*
    $24.8
    *59%*
    20%Research
      & Development Revenue
    $0.3
    *1%*
    $0.5
    *1%*
    (45%)Royalty
      Income
    $15.2
    *33%*
    $16.7
    *40%*
    (9%)EXPENSES:Cost
      of Products Sold
    $12.2
    *27%*
    $11.2
    *27%*
    9%Research
      & Development Expense
    $11.8
    *26%*
    $12.6
    *30%*
    (7%)Selling,
      General & Administrative Expense
    $8.4
    *19%*
    $6.3
    *15%*
    34%INTEREST
      INCOME
    $0.9
    *2%*
    $0.9
    *2%*
    10%NET
      INCOME
    $9.6
    
    $8.8
    
    10%


*Revenues.* Revenues
increased 8% to $45.1 million in the nine months ended March 31, 2005 from $41.9
million in the nine months ended March 31, 2004.





*Net
Sales* . Net
sales of products increased 20%, to $29.7 million from $24.8 million for the
nine months ended March 31, 2005 and 2004, respectively. These increases were
attributable to increased sales of both our orthopaedic and cardiology
products.





Cardiology
biomaterial sales increased 24% to $11.9 million from $9.6 million for the nine
months ended March 31, 2005 and 2004. This increase related to sales of the
collagen plug component of the Angio-Seal product to St. Jude Medical, which
increased $2.6 million, or 39% over the prior year comparable period offset by a
decrease in sales of the polymer anchor component of the Angio-Seal device,
which decreased $534,000, or 18% over the prior year comparable period. This
decrease related to the transition of the manufacture of the absorbable polymer
anchor from us to St. Jude Medical.





Orthopaedic
sales increased 16% to $16.5 million from $14.2 million for the nine months
ended March 31, 2005 and 2004, respectively. This increase was the result of
sales of VITOSS FOAM bone graft substitute products to Orthovita totaling $4.8
million. This $4.8 million increase was offset by a $2.2 million decrease in
sales of sports medicine products to Arthrex to $9.4 million from $11.6 million
in the same period of the prior year. This decrease was anticipated and, as
discussed above, related primarily to inventory planning adjustments by Arthrex.
Sales levels of our sports medicine products in the fourth quarter of fiscal
2005 are estimated to remain relatively consistent with the levels experienced
in the third quarter of fiscal 2005. Net sales for the nine months ended March
31, 2005 and March 31, 2004 consisted almost entirely of biomaterials sales, as
TriActiv System sales were less than 1% of total sales in both
periods.





29




*Research
and Development Revenues.* Research
and development revenues decreased 45% to $253,000 from $462,000 for the nine
months ended March 31, 2005 and 2004, respectively. The revenues for the nine
months ended March 31, 2005 consisted of amounts generated under our NIST
vascular graft grant. In the comparable p rior year
period, revenues were generated
under the NIST vascular graft grant ($408,000) and the NIH breast cancer drug
delivery grant ($54,000). The decrease from the prior year period reflects the
completion of the two grants, the NIST vascular grant, which concluded during
the first half of fiscal 2005 and the NIH Breast Cancer Drug Delivery grant
which concluded in the first half of fiscal 2004. The NIST vascular graft grant
concluded in September 2004 and resulted in a decrease of $155,000 from the
comparable period in the prior year. The NIH breast cancer drug delivery grant
concluded in October 2003 and resulted in a $54,000 decrease from the comparable
period in the prior year.





The
following table summarizes the research and development revenue for the nine
months ended March 31, 2005 compared to March 31, 2004:





**Grant**
    
    **Nine
      months ended March 31, 2005**
    
    **Nine
      months ended March 31, 2004**
    
    **Percentage
      Change from FY 04 to FY 05**NIST
      Vascular Graft
    
    $
    253,292
    
    $
    408,285
    
    
    (38%)NIH
      Breast Cancer Drug Delivery
    
    $
    0
    
    $
    53,923
    
    
    (100%)**Total
      R&D Revenue**
    
    **$**
    **253,292**
    
    **$**
    **462,208**
    
    
    **(45**%)****





*Royalty
Income.* Royalty
income decreased 9% to $15.2 million from $16.7 million in the nine months ended
March 31, 2005 and 2004, respectively. This decrease was due to a decline in our
Angio-Seal royalties offset by the addition of the Orthovita royalty in March
2004.





Angio-Seal
end-user sale unit sales increased 22%, to approximately $223 million during the
nine months ended March 31, 2005 compared to approximately $183 million sold
during the nine months ended March 31, 2004. In addition to the increase in the
number of units St. Jude Medical sold, another reason for the increase in
Angio-Seal sales was an increase in the average selling price for the Angio-Seal
device, which increased year over year, partially due to favorable currency
exchange rates on sales in Europe. These increases were offset by the 33%
contracted royalty rate decline from 9% to 6%, which occurred in April 2004. As
a result, Angio Seal royalties decreased 19% from $16.6 million to $13.5 million
in the nine months ended March 31, 2004 and 2005, respectively.





Partially
offsetting the Angio-Seal royalty income decrease were royalties from Orthovita
under the March 2003 manufacturing, development and supply agreement between our
two companies and the acquisition of the separate VITOSS proprietary rights from
a third party inventor of the VITOSS technology, both of which are discussed
above. See Note 1 to the Condensed Consolidated Financial Statements - Patents
and Proprietary Rights. Total royalty income from Orthovita was approximately
$1.7 million for the nine months ended March 31, 2005.





*Cost
of Products Sold.* Cost of
products sold increased 9% from $11.2 million in the nine months ended March 31,
2004 to $12.2 million in the nine months ended March 31, 2005. While
overall cost of products sold increased, gross margin also increased to 59% from
55%. This increase reflected a favorable product mix of our biomaterials
products in addition to manufacturing efficiencies on mature products, resulting
in a decrease in per unit costs.





*Research
and Development Expenses.* Research
and development expenses decreased 7% to $11.8 million in the nine months ended
March 31, 2005 from $12.6 million in the nine months ended March 31, 2004. This
decrease related primarily to research and development expenses related to the
TriActiv System which decreased $1.3 million, or 16%, to $6.7 million in the
nine months ended March 31, 2005 compared to $8.0 million in the nine months
ended March 31, 2004. The decrease was mainly attributable to a decrease of $2.7
million in clinical trial expenses due to the conclusion of the PRIDE clinical
trial in March 2004. This decrease was largely offset by increases in personnel costs,
including travel expenses, restricted share and incentive compensation
expense ($998,000), facility costs ($165,000) and legal and consulting expenses
($178,000) all in support of the continued development on both the current
TriActiv System as well as future applications of the device, including the
TriActiv FX System.





30





We also
continued our development efforts on our biomaterials products, including our
work on cartilage regeneration and our synthetic vascular graft.
Biomaterials-related spending increased $442,000, or 10%, to $5.0 million in the
nine months ended March 31, 2005 from $4.6 million in the nine months ended
March 31, 2004 related primarily to increases in personnel costs totaling
$298,000 and operational expenses totaling $196,000 to support our continued
development of potential new products and processes for our current and
prospective customers. These increases were offset by decreases in depreciation
expense ($109,000) on equipment used for the NIST vascular graft grant and the
NIH breast cancer drug delivery grants. According to the requirements of the
grant, this equipment must be fully depreciated by the time the grants conclude.
As discussed above, the NIST vascular graft grant concluded in September 2004
and the NIH breast cancer drug delivery grant concluded in October 2003. We
still maintain possession of this equipment and it is being used for further
research in both of these technologies.





*Selling,
General and Administrative.* Selling,
general and administrative expense increased 34%, or $2.1 million, to $8.4
million in the nine months ended March 31, 2005 from $6.3 million in the nine
months ended March 31, 2004. This
increase was primarily the result of general and administrative expenses, which
increased 48% to $4.7 million in the nine months ended March 31, 2005 from $3.2
million in the nine months ended March 31, 2004. This was attributable to a
$605,000 increase in personnel costs ,
including restricted stock and incentive compensation expense, as well
as a $246,000 increase in professional services and public company expenses,
which include D&O insurance, board of director costs and SEC filing fees. Personnel
expense has increased due to the expensing of restricted shares, increased cash
incentive plans to offset reduced stock option awards and expenses related to
the implementation of our new ERP system. Professional
service fees and public company expenses increased as a result of new SEC and
governmental regulations, primarily Sarbanes-Oxley. In
addition, collection
of $101,000 that had been specifically reserved in our allowance for doubtful
accounts during the period ended March 31, 2004 versus the current period bad
debt expenses of $82,000, resulted in a $183,000 increase from the prior year
comparable period. Additionally,
there was a $347,000 expense in the first nine months of fiscal 2005 related to
the amortization of intellectual proprietary rights acquired in August 2004. The
entire cost of these proprietary rights is being amortized over a 60-month
period, the estimated period of economic benefit (See Note 1 - Patents and
Proprietary Rights).





Sales and
marketing expenses increased 19%, or $583,000, to $3.6 million in the nine
months ended March 31, 2005 from $3.0 million in the nine months ended March 31,
2004. This increase was primarily the result of our U.S. commercial launch
efforts for the TriActiv System. Personnel and travel expenses for the U.S.
sales and marketing department increased $411,000 relating to the expenses of
the TriActiv direct sales force. As of March 31, 2005, we had 9 sales
representatives, 3 members of senior management, and one clinical sales support
member hired for our sales team. Travel costs increased due to training
conducted for the new sales team as well as post-launch travel to prospective
customers/hospitals. In addition, there was an increase of $133,000 in marketing
expenses related to pre-launch activities such as product training for the new
sales team and the creation of marketing materials.





The
TriActiv System European sales and marketing costs increased 3%, or $61,000.
This increase was due partially to an expense related to currency translation.
The exchange rate of the euro to the dollar increased on average 7% from the
nine months ended March 31, 2004 to the nine months ended March 31, 2005. This
equates to approximately a $123,000 increase in expenses related specifically to
the change in the currency rate. In addition to the effect of currency
translation (and excluding such effect from each of the following items),
personnel and convention expenses increased approximately $106,000, marketing
expenses such as product samples and advertising increased by $63,000 and office
costs increased by $25,000. These increases were offset by a decrease, again
excluding the effect of translation, of $239,000 related to a clinical study to
support reimbursement of the product in Europe. This study concluded in December
2004.





31


**


*Net
Interest Income.* Interest
income increased to $933,000 in the nine months ended March 31, 2005 from
$852,000 in the nine months ended March 31, 2004. Although our cash and
investment balances decreased by 15% over the comparable prior year period, this
decrease was more than offset by higher interest rates. Interest expense
decreased 92% to $4,600 in the nine months ended March 31, 2005 from $56,000 in
the nine months ended March 31, 2004. This decrease was directly related to debt
on the THM Obligation, which was paid in full as of September 30, 2004.





*Other
Income.*  Other
non-operating income was $66,000 in the nine months ended March 31, 2005
compared to $2,300 in the nine months ended March 31, 2004. This increase
related to gain on disposal of assets totaling $32,000 and $33,784 of revenue
recognized from a $500,000 opportunity grant we received from the Commonwealth
of Pennsylvania Governor’s Action Team. (See Liquidity and Capital Resources
Section and Note 10.)





**Liquidity
and Capital Resources**





Our cash,
cash equivalents and investments were $46.5 million at March 31, 2005, a
decrease of $14.6 million from our balance of $61.1 million at June 30, 2004,
the end of our prior fiscal year. In addition, our working capital was $63.3
million at March 31, 2005, a decrease of $9.4 million from our working capital
of $72.7 million at June 30, 2004.





***Operating
Activities***


Net cash
provided by our operating activities was $9.2 million in the nine months ended
March 31, 2005. For the nine months ended March 31, 2005, we had net income of
$9.6 million, a tax benefit from the exercise of stock options of $405,000,
non-cash employee stock-based compensation of $508,000, and non-cash
depreciation and amortization of $4.1 million. Cash used as a result of changes
in asset and liability balances was $5.5 million. The decrease in cash related
to the change in assets and liabilities was primarily due to an increase in
accounts receivable ($4.0 million), inventory ($1.4 million) and prepaids and
other assets ($1.2 million) and a decrease in accounts payable and accrued
expenses ($779,000). This was partially offset by an increase in non-current
deferred revenue ($385,000) and a decrease in the deferred tax asset and an
increase in the non-current deferred tax liability, which provided cash of
$876,000 and $677,000, respectively.





The
increase in accounts receivable related primarily to a late payment by one of
our largest customers, which we received in early April, as well as the
increased sales volume during the last few weeks of the third quarter of fiscal
2005 as compared to the same period of fiscal 2004. The increase in inventory
related to the build up of TriActiv component parts in preparation of our
commercial launch, an increase in our inventory of Orthovita components as well
as a small increase in our polymer raw material costs in anticipation of our
next quarter sales. The increase in prepaids and other assets related to an
increase in prepaid insurance ($295,000), deposits on equipment ($858,000) and
our general prepaid balance for various company expenses, including but not
limited to, maintenance contracts, future exhibition expenses, and dues and
subscriptions ($87,000). The increase in accounts payable and accrued expenses
related to an increase in our trade accounts payable specifically for purchases
related to our new building and our business expansion This increase was offset
by federal tax payments made during fiscal 2005. The increase in deferred
revenue related to the opportunity grant received from the Department of
Economic Development of the Commonwealth of Pennsylvania (see below). The
decrease in the deferred tax asset and increase in the non-current tax liability
was primarily due to the utilization of our deferred tax asset and the recording
of a future year tax liability.





32


******


***Opportunity
Grant***


In
November 2004, the Company was awarded a $500,000 opportunity grant from the
Department of Community and Economic Development of the Commonwealth of
Pennsylvania. This grant was awarded to the Company for the potential
job-creating economic development opportunities created by the Company’s
construction of its new facility within the state of Pennsylvania. The grant is
conditioned upon meeting the following: (1) the Company will create 238
full-time jobs within 5 years, beginning April 1, 2003, the date of the
Company’s request for the grant, (2) the Company will invest at least
$54,250,000 in total project costs, including, but not limited to, personnel,
land and building construction within three years, beginning July 19, 2004, the
date of the Company’s facility groundbreaking and (3) the Company will operate
at its new facility for a minimum of 5 years. The Company received the cash
payment of $500,000 in its third fiscal quarter 2005. Revenue will be recognized
as earned over the longest period contained within the grant commitment terms
(five years from the date of occupancy of the Company’s new facility). This date
of satisfaction of the last grant commitment is expected to be in December 2010,
assuming the current expectation for a transition to the new facility in January
2006. As of March 31, 2005 approximately $34,000 of revenue was recognized
related to this grant as a component of Other Income.





***Investing
Activities***


Cash used
in investing activities was $14.0 million for the nine-month period ended March
31, 2005. This was the result of purchase and redemption activity within our
investment portfolio and capital spending related to the construction of our new
facility (see below) and ongoing expansion of our manufacturing capabilities. In
addition, we spent $2.6 million for the acquisition of the
intellectual property rights of an inventor of the VITOSS technology and
$250,000 for the acquisition of patents and proprietary rights  complimentary
to our biomaterials platform . (See
Note 1 to the Condensed Consolidated Financial Statements - Patents and
Proprietary Rights).





During
the period, investments of $22.3 million either matured, were sold or were
called. We subsequently purchased new investments with these proceeds for total
investment purchases of $19.5 million, providing net cash through investment
activity of $2.8 million. See Note 1 to the condensed consolidated financial
statements included in this quarterly report for a description of our
available-for sale securities.





We have a
$25.0 million capital spending plan for fiscal 2005, of which up to $20 million
was authorized for our new facility (see discussion below) by the end of our
fiscal 2005, and the remainder will be expended to continue to expand our
research and development and manufacturing capabilities and upgrade our
Management Information Systems (MIS) technology infrastructure. Of this total
plan, we have spent $13.9 million during the nine months ended March 31, 2005 of
which $4.7 million related to ongoing operations of the Company. The remaining
$9.2 million was for the purchase of land and construction of our new facility.





***New
Facility***


Our new
facility will be located in the general vicinity of our existing facility. Long
term, the proposed building site will be able to accommodate a 220,000 square
foot facility and thus provide for our future growth and continued expansion.
Our construction plan has three phases. Phase one is the construction of a
160,000 square foot building shell and the fit-out of 90,000 square feet of
space for our manufacturing and quality assurance operations. Phase one which
began in the first fiscal quarter of 2005 is expected to be completed early in
our third quarter of fiscal 2006 and have a total estimated cost of $35 million,
including the land purchase. Phase two will complete the interior fit-out of the
160,000 square feet and is anticipated to be complete within four months of
phase one, or in the fourth quarter of fiscal 2006. The second phase would allow
the complete transition of all our personnel and operations to the new facility,
with the exception of our model shop. Phase three would bring the building to
198,000 square feet, both shell and fit-out, and allow us to bring the entire
organization into the new facility and is expected to be complete by the end of
fiscal 2006. We are currently obtaining construction bids for the phase two and
three portions of the facility project. Our current plan is to finance the
construction of this building from current available cash on hand or liquid
investments.





33





Management
has formalized its plans for transition to the new facility and is in the
process of evaluating the impact of such transition on the results of operations
for the remainder of fiscal 2005 and through fiscal 2006. We anticipate an
acceleration of depreciation on the leasehold improvements in our current leased
facility, which we will abandon when we transition to the new facility. This
acceleration would begin in our fourth fiscal quarter of 2005 and continue, in
some cases, through the end of fiscal 2006, the final phase of transition. The
carrying value of all leasehold improvements is approximately $4.3 million at
March 31, 2005. In addition to the accelerated depreciation, we are developing
estimates of our moving costs, many of which will be capitalized in conjunction
with getting our machinery and equipment into its new locations and into
operable condition.





***Financing
Activities***


Cash used
in financing activities was $6.3
million for the nine-month period ended March 31, 2005. This was the result of
repayments of long-term debt ($219,000) and stock repurchases ($6.9 million)
offset by proceeds from the exercise of stock options. The
exercise of stock options provided cash of $782,000 for the nine months ended
March 31, 2005. We believe that option exercises are likely to continue through
fiscal 2005 due to the current market price of our common stock compared to the
average exercise price of outstanding options.





***Debt***


On
September 1, 2000, we incurred an obligation in the amount of $4.5 million in
conjunction with the acquisition of THM Biomedical, Inc. The obligation was due
in equal quarterly installments. In September 2004 the entire obligation was
paid in full. No debt remained on our balance sheet as of March 31,
2005.





***Stock
Repurchase Program***


On August
17, 2004, we announced that our Board of Directors had reinstated a program to
repurchase issued and outstanding shares of Common Stock over six months from
the date of the board reinstatement. The reinstated plan called for the
repurchase of up to 259,000 shares, the balance under the original plan approved
in October 2003. In the nine months ended March 31, 2005, we
repurchased and retired 199,867 shares of common stock under the reinstated
program at a cost of approximately $5.1 million, or an average market price of
$25.72 per share. This
program expired in February 2005.





On March
16, 2005, we announced a new stock repurchase program under which our Board of
Directors authorized the repurchase of up to 400,000 shares of our issued and
outstanding Common Stock through September 30, 2005. As with the first stock
repurchase program, we plan to continue to repurchase our shares for cash, from
time to time in the open market, through block trades or otherwise. The
repurchase program does not require us to purchase any specific dollar value or
number of shares. Any further purchases under the program will depend on market
conditions and may be commenced or suspended at any time or from time to time
without prior notice. As of March 31, 2005 we had repurchased and retired 64,133
shares of common stock under this new program at a cost of approximately $1.7
million, or an average market price of $27.00 per share. We financed this
repurchase using our available cash. At March 31, 2005, there were 335,867
shares remaining for repurchase under this program.





34


******


***Research
and Development Tax Credit*** **


During
the fourth quarter of fiscal year 2003, we performed a retrospective research
and development tax credit study for fiscal years 1993 through 2003. We recorded
the majority of this tax credit ($1.5 million) in the fourth quarter of fiscal
2003. During the first quarter of our fiscal 2004, we recorded an additional
portion of the research and development tax credit ($310,000) and professional
service fees as a component of selling, general and administrative expenses
($50,500) related to this research and development tax credit study.





***General***


We plan
to continue to spend substantial amounts to fund clinical trials, to gain
regulatory approvals and to continue to expand research and development
activities, particularly for the TriActiv System and our biomaterials products.
We will continue the construction of our new facility to support the continued
growth of our biomaterials business and the commercialization of the TriActiv
System. We are marketing and selling the TriActiv System in the U.S. through a
direct sales force which was comprised of 9 sales people, 3 management team
members and 3 clinical sales support personnel as of the end of our third fiscal
quarter. Our sales
and marketing expenses are expected to increase $2.0 million to $2.5 million,
including personnel and marketing expenses related to our TriActiv launch, in
fiscal 2005 over fiscal 2004. We
believe our current cash and investment balances, in addition to cash generated
from operations, will be sufficient to meet our operating, financing and capital
requirements through at least the next 12 months. We also believe our cash and
investment balances will be sufficient on a longer term basis, however, that
will depend on numerous factors, including market acceptance of our existing and
future products; the successful commercialization of products in development and
costs associated with that commercialization; progress in our product
development efforts; the magnitude and scope of such efforts; progress with
pre-clinical studies, clinical trials and product clearance by the FDA and other
agencies; the cost and timing of our efforts to expand our manufacturing, sales,
and marketing capabilities, including our new facility; the cost of filing,
prosecuting, defending and enforcing patent claims and other intellectual
property rights; competing technological and market developments; and the
development of strategic alliances for the marketing of certain of our products.





The terms
of any future equity financing we undertake may be dilutive to our stockholders
and the terms of any debt financing may contain restrictive covenants that limit
our ability to pursue certain courses of action. Our ability to obtain financing
is dependent on the status of our future business prospects, as well as
conditions prevailing in the relevant capital markets. No assurance can be given
that any additional financing will be available to us, or will be available to
us on acceptable terms’ should such a need arise.





*Our
estimate of the time periods for which our cash and cash equivalents will be
adequate to fund operations is a forward looking statement within the meaning of
Private Securities Litigation Reform Act of 1995 and is subject to risks and
uncertainties. Actual results may differ materially from those contemplated in
such forward-looking statements. In addition to those described above, factors
which may cause such a difference are set forth below under the caption “Risks
Related to our Business” below.*





**Risks
Related to Our Business**





There are
many risk factors that could adversely affect our business, operating results,
financial condition and prospects, and/or the market price of our common stock.
These risk factors, most of which have been described in detail in our Annual
Report on Form 10-K for the fiscal year ended June 30, 2004 as well as our Form
10-Q for the quarter December 31, 2004, under “ *Risk
Factors* ,”
include but are not limited to:





·
    our
      ability to successfully commercialize the TriActiv System in the U.S.
      through a direct sales force;


·
    our
      ability to successfully commercialize the TriActiv System in the European
      Union;


·
    the
      completion of additional clinical trials in both the U.S. and Europe to
      support regulatory approval of future generations of the TriActiv
      device;


·
    our
      ability to scale up the manufacturing of TriActiv devices to accommodate
      the respective sales volume;




35




·
    our
      ability to obtain any additional required funding for future development
      and marketing of the TriActiv, as well as our biomaterials
      products;


·
    our
      reliance on a majority of our sales revenues from only three
      customers;


·
    our
      reliance on revenues, including both royalty income and product sales,
      from the Angio-Seal product line;


·
    the
      performance of St. Jude Medical as the manufacturer, marketer and
      distributor of the Angio-Seal product;


·
    our
      dependence on the continued growth and success of our biomaterials
      products and customers;


·
    our
      dependence on our biomaterials customers for planning their inventories,
      marketing and obtaining regulatory approval for their
      products;


·
    the
      competitive markets for our products and our ability to respond more
      quickly than our competitors to new or emerging technologies and changes
      in customer requirements;


·
    the
      acceptance of our products by the medical
community;


·
    our
      dependence on key customers, vendors and
personnel;


·
    the
      use of hazardous materials, which could expose us to future environmental
      liabilities;


·
    the
      international market risks that can harm future international sales of our
      products;


·
    our
      ability to expand our management systems and controls to support
      anticipated growth;


·
    potential
      dilution of ownership interests of our stockholders by stock issuances in
      future acquisitions or strategic alliances;


·
    our
      ability to transition to our new manufacturing facility in order to meet
      our customers’ requirements;


·
    risks
      related to our intellectual property, including patent and proprietary
      rights and trademarks; and


·
    risks
      related to our industry, including potential for litigation, product
      liability claims, ability to obtain reimbursement for our products and our
      products’ exposure to extensive government
regulation;


·
    adherence
      and compliance with corporate governance laws, regulations and other
      obligations affecting our business.





**CAUTIONARY
NOTE REGARDING FORWARD-LOOKING STATEMENTS**





This
report includes forward-looking statements within the meaning of
Section 21E of the Securities Exchange Act of 1934 and Section 27A of the
Securities Act of 1933. We have based these forward-looking statements largely
on our current expectations and projections about future events and trends
affecting our business. In this report, the words "believe," "may," "will,"
"estimate," "continue," "anticipate," "intend," "expect," “plan” and similar
expressions, as they relate to Kensey Nash, our business or our management, are
intended to identify forward-looking statements, but they are not exclusive
means of identifying them.





A number
of risks, uncertainties and other factors could cause our actual results,
performance, financial condition, cash flows, prospects and opportunities to
differ materially from those expressed in, or implied by, the forward-looking
statements. These risks, uncertainties and other factors include, among other
things:





Ÿ
    general
      economic and business conditions, both nationally and in our
      markets;





Ÿ
    the
      impact of competition;





Ÿ
    anticipated
      trends in our business;





Ÿ
    existing
      and future regulations affecting our
business;





Ÿ
    strategic
      alliances and acquisition opportunities;
and





Ÿ
    other
      risk factors set forth under “Risks Related to our Business”
      above.





36





Except as
expressly required by the federal securities laws, we undertake no obligation to
publicly update or revise any forward-looking statements, whether as a result of
new information, future events or otherwise after the date of this report. Our
results of operations in any past period should not be considered indicative of
the results to be expected for future periods. Fluctuations in operating results
may also result in fluctuations in the price of our common stock.





***Item
3. Quantitative and Qualitative Disclosures about Market
Risk***





Our
interest income and expense are sensitive to changes in the general level of
interest rates. In this regard, changes in interest rates affect the interest
earned on our cash, cash equivalents and investments.





Our
investment portfolio consists primarily of high quality U.S. government,
municipal and corporate securities with
maturities ranging primarily from 1 to 5 years, with one security having a
maturity of 11 years. Also, the portfolio includes certain municipal variable
rate demand obligations that have maturities ranging from 5 to 31 years. These
municipal variable-rate demand obligations are putable weekly and callable on a
monthly basis. We mitigate default risk by investing in what we believe are safe
and high credit quality securities and by monitoring the credit rating of
investment issuers. Our portfolio includes only marketable securities with
secondary or resale markets. We have an audit committee approved investment
strategy, which provides guidance on the duration and types of our investments.
These available-for-sale securities are subject to interest rate risk and
decrease in market value if interest rates increase. At March 31, 2005, our
total portfolio consisted of approximately $43.0 million of investments.
While our investments may be sold at anytime because the portfolio includes
available-for-sale marketable securities with secondary or resale markets, we
generally hold securities until the earlier of their call date or their
maturity. Therefore, we do not expect our results of operations or cash flows to
be materially impacted due to a sudden change in interest rates.





***Item
4. Controls and Procedures***





We
carried out an evaluation, under the supervision and with the participation of
our management, including our Chief Executive Officer and Chief Financial
Officer, of the design and operation of our disclosure controls and procedures.
Based on this evaluation, our Chief Executive Officer and Chief Financial
Officer concluded that, as of March 31, 2005, our disclosure controls and
procedures were effective to provide reasonable assurance that the information
required to be disclosed by us in the reports filed or submitted under the
Securities Exchange Act of 1934 (1) is recorded, processed, summarized and
reported within the time periods specified in the SEC’s rules and forms and (2)
is accumulated and communicated to our management, including our chief executive
officer and chief financial officer, as appropriate, to allow timely decisions
regarding required disclosure.





There was
not any change in the our internal control over financial reporting during the
quarter ended March 31, 2005 that has materially affected, or is reasonably
likely to materially affect, our internal control over financial
reporting.





Any
control system, no matter how well designed and operated, can provide only
reasonable (not absolute) assurance that its objectives will be met.
Furthermore, no evaluation of controls can provide absolute assurance that all
control issues and instances of fraud, if any, have been detected.




37





**Part
II - OTHER INFORMATION**





***Item
2. Unregistered Sales of Equity Securities and Use of
Proceeds.***





The
following table contains information about our repurchases of our equity
securities during January, February, and March 2005:




**Period**
    
    ********Total**Number of**Shares**Purchased**
    
    ********Average**Price**Paid
      per**Share**
    
    ********Total
      Number of**Shares**
      **Purchased**as
      Part of**
      **Publicly**Announced**
      **Programs**
    
    ********Maximum**
      **Number**
      of Shares that
      May
      Yet Be
      Purchased
      Under Open
      Programs******January
      1-31, 2005
    
    
    —
    
    **$******
    **—**
    
    
    **—**
    
    
    **—**February
      1-28, 2005
    
    
    **—**
    
    
    **—**
    
    
    **—**
    
    
    **—**March
      1-31, 2005
    
    
    64,133
    
    
    27.00
    
    
    64,133
    
    
    335,867Total
    
    
    64,133
    
    $
    27.00
    
    
    64,133
    
    
    335,867


On March
16, 2005, we announced another stock repurchase program under which an
additional 400,000 shares of our issued and outstanding shares of Common Stock
were approved by the Board of Directors for repurchase through September 30,
2005. Under the plan, 335,867 shares are still available for repurchase.





Our
reinstated repurchase program, which was announced in August 2004 expired in
February 2005. The reinstated plan called for the repurchase of up to 259,000
shares, the balance under the original plan approved in October 2003. As of
February 2005, we repurchased and retired 199,867 shares of common stock under
the reinstated program at a cost of approximately $5.1 million, or an average
market price of $25.72 per share.





38


******


***Item
6. Exhibits.***




10.1
    Amendment
      to the Development and Distribution Agreement dated February 28, 2005
      between Kensey Nash Corporation and Orthovita, Inc..
 
 31.1
    Certification of Chief Executive Officer pursuant to
      Exchange Act Rule 13a-14(a).
 
 31.2
    Certification of Chief Financial Officer pursuant to
      Exchange Act Rule 13a-14(a).
 
 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.




39








**SIGNATURES**




Pursuant
to the requirements of the Securities Exchange Act of 1934, the registrant has
duly caused this report to be signed on its behalf by the undersigned thereunto
duly authorized.




KENSEY NASH
      CORPORATIONDate:May
      10, 2005
    By:
    /s/ Wendy F. DiCicco,
  CPAWendy F. DiCicco, CPAChief Financial
      Officer
      (Principal Financial and Accounting
    Officer)




40