Net Income

                                         Three Months Ended                                Nine Months Ended
                                           September 30,                                     September 30,
(dollars in thousands,                                          Percent                                            Percent
except per share amounts)   2008       2007        Change       Change        2008        2007        Change       Change
Net income                  $  58     $ 1,604     $ (1,546 )         -96 %   $ 2,612     $ 1,811     $    801            44 %
Earnings per share:
Basic                       $   -     $   .09                                $   .15     $   .10
Diluted                     $   -     $   .09                                $   .15     $   .10

The decline in net income in the third quarter of 2008 compared to the prior year period primarily resulted from lower revenue and a one point decline in gross margin. The improvement in net income for the nine months ended September 30, 2008, compared to the prior year period, resulted from increased revenue and improved gross margins which were partially offset by higher operating expenses and a higher effective tax rate. Net income for the nine months ended September 30, 2008 was also positively impacted by a gain realized in the second quarter of 2008 from the settlement of certain litigation in the amount of $1.0 million.
Net income for the three and nine months ended September 30, 2007, was generated primarily by increased revenue and improved gross margin, which was partially offset by higher operating expenses. Net income in 2007 was negatively impacted by the first quarter charge of approximately $1.1 million for the settlement of certain litigation.

Revenue
For the nine months ended September 30, 2008, revenue increased 2% but declined 6% for the three months ended September 30, 2008, compared to the same respective prior year periods. The products in the DBM and Hybrid/Synthetic Segments compose our primary product areas and are designated as such because they are the focus of our research and development initiatives and we believe they offer us the highest potential for revenue growth and profitability improvements. Revenue from these product lines declined 16% in the third quarter of 2008 but were constant in the nine months ended September 30, 2008, compared to the prior year respective periods. We plan to focus our strategic efforts on expanding the domestic and international markets for our current and future primary product lines.
The following table details the components of revenue for the three and nine months ended September 30, 2008 and 2007:

                                        Three Months Ended                                   Nine Months Ended
                                          September 30,                                        September 30,
                                                                 Percent                                              Percent
(dollars in thousands)     2008         2007        Change       Change         2008         2007        Change       Change
DBM                      $ 14,023     $ 17,044     $ (3,021 )         -18 %   $ 47,564     $ 48,687     $ (1,123 )          -2 %
Hybrid/Synthetic              816          528          288            55 %      2,187        1,169        1,018            87 %
Traditional Tissue          5,246        3,963        1,283            32 %     15,606       13,132        2,474            19 %
Spinal Allograft            1,943        2,292         (349 )         -15 %      6,479        8,301       (1,822 )         -22 %
Client Services             1,706        1,664           42             3 %      6,527        5,536          991            18 %
Other                         329          160          169           106 %        884          513          371            72 %

                         $ 24,063     $ 25,651     $ (1,588 )          -6 %   $ 79,247     $ 77,338     $  1,909             2 %

DBM Segment revenue, which consists of revenue from the sale of Grafton® DBM and Xpanse® Bone Inserts and revenue from the processing of two private label DBMs, declined 18% and 2% for the three and nine months ended September 30, 2008, respectively, as compared to the same periods in 2007, primarily as a result of the decline in private label revenue. Revenue from Grafton® DBM, private label DBM tissue forms and Xpanse® Bone Inserts changed (3)%, (96)% and (31)%, respectively, in the third quarter of 2008 compared to the third quarter of 2007 and 4%, (49)% and 20% respectively in the nine months ended September 30, 2008 compared to 2007. We have been formally advised that one of our private label DBM customers does not intend to renew its current agreement with us upon the agreement's expiration in March 2009. We recognized $.5 million of revenue from this customer in the first quarter of 2008 and the customer has not made any purchases since. The decline in purchases by this customer is the primary reason for the decline in private label DBM revenue in the three and nine months ended September 30, 2008.
Revenue in the Hybrid/Synthetic Segment, which reflects sales of our Plexur P™ Biocomposite and GraftCage® Spacers, increased 55% and 87% in the three and nine months ended September 30, 2008, respectively, as compared to the same periods of 2007 primarily as a result of increased Plexur P™ revenue.
Traditional Tissue Segment revenue, which represents the worldwide distribution of allograft bone tissue grafts, increased 32% and 19% for the three and nine months ended September 30 of 2008, respectively, as compared to the same periods in 2007. The increase in 2008 traditional tissue revenue resulted from increased unit sales volume.
Revenue in the Spinal Allograft Segment declined 15% and 22% in the three and nine months ended September 30, 2008, respectively, as compared to the same periods in 2007, primarily due to a decrease in unit sales volume. Client Services Segment revenue, which is generated by the processing of allograft bone tissue for our clients, mainly the Musculoskeletal Transplant Foundation ("MTF"), increased 3% and 18% in the three and nine months ended September 30, 2008, respectfully, as compared to the same periods in 2007. Our contractual agreements with MTF expire at the end of 2008 and, beginning in 2009, we expect revenue in this segment to be insignificant. Other revenue consists mainly of revenue from revenue related to the international distribution of xenograft tissue grafts, sales commissions for the distribution of traditional tissue processed by others and revenue from the distribution of the Kinesis™ BMAC™ system. During the third quarter and the nine months ended September 30, 2008, other revenue increased 106% and 72%, respectively, compared to the same periods in 2007.
In the three and nine months ended September 30, 2008, MTF accounted for $2.9 million and $10.6 million, respectively, of revenue. MTF accounted for $3.7 million of revenue for the three months ended September 30, 2007 and $12.4 million of revenue for the nine months ended September 30, 2007.

Gross Profit Margin

                                    Three Months Ended          Nine Months Ended
                                       September 30,              September 30,
         (dollars in thousands)      2008          2007         2008          2007
         Gross Profit             $   12,881     $ 14,208     $  41,625     $ 39,315
         Gross Margin                     54 %         55 %          53 %         51 %

In the nine months ended September 30, 2008, gross margin improved over gross margin levels in the comparable 2007 period, primarily due to increased unit processing volumes and better management of inventory risk exposures, such as obsolescence. In the three months ended September 30, 2008, changes in the components of segment revenue resulted in a lower gross margin compared to the prior year period.
Operating Expenses

                                          Three Months Ended                                      Nine Months Ended
                                            September 30,                                           September 30,
                                                                    Percent                                                 Percent
(dollars in thousands)      2008          2007        Change        Change          2008          2007        Change        Change
Marketing, selling and
general and
administrative            $ 10,476      $ 10,981      $  (505 )           -5 %    $ 33,479      $ 33,105      $   374              1 %
Research and
development                  1,739         1,248          491             39 %       5,273         3,693        1,580             43 %

Total                     $ 12,215      $ 12,229      $   (14 )            - %    $ 38,752      $ 36,798      $ 1,954              5 %

Marketing, selling and general and administrative expenses declined 5% in the third quarter and increased 1% in the nine months ended September 30, 2008 as compared to the same respective periods in 2007. In both the three and nine months ended September 30, 2008, we had higher non-cash stock compensation costs and marketing and selling expenses, compared to the prior year, offset by lower performance based compensation expense. In the nine months ended September 30, 2007, we incurred $1.1 million in costs associated with the settlement of and legal fees incurred in connection with certain litigation.
In the third quarter and nine months ended September 30, 2008, research and development expenses increased 39% and 43%, respectively, as compared to the same periods in 2007, primarily due to the costs incurred for basic research, product development and process development activities to support the technologies and products we currently distribute or are developing for future commercialization.

Operating Income (Loss) By Segment

                                        Three Months Ended                                    Nine Months Ended
                                          September 30,                                         September 30,
                                                                 Percent                                                Percent
(dollars in thousands)     2008         2007        Change       Change         2008          2007         Change       Change
DBM                      $  4,262     $  6,557     $ (2,295 )         -35 %   $  15,345     $  14,196     $  1,149             8 %
Hybrid/Synthetic              104         (373 )        477           128 %          (2 )        (370 )        368            99 %
Traditional Tissue            923          439          484           110 %       2,449         2,381           68             3 %
Spinal Allografts            (116 )        772         (888 )        -115 %        (100 )       1,812       (1,912 )        -106 %
Client Services               956        1,167         (211 )         -18 %       4,002         4,172         (170 )          -4 %
Other                         115           48           67           140 %         577           226          351           155 %

                            6,244        8,610       (2,366 )         -27 %      22,271        22,417         (146 )          -1 %
Corporate                  (5,578 )     (6,631 )      1,053            16 %     (19,398 )     (19,900 )        502             3 %

Operating income         $    666     $  1,979     $ (1,313 )         -66 %   $   2,873     $   2,517     $    356            14 %

Total product segment operating income for the three and nine months ended September 30, 2008 declined 27% and 1%, respectively, as compared to comparable 2007 periods. In the third quarter of 2008, segment operating income was negatively impacted by a lower gross margin and higher operating expenses, while in the nine months September 30, 2008 higher operating expenses were substantially offset by higher gross profit. In the three and nine months ended September 30, 2008, product segment operating income, as a percent of revenue; declined 26% and 28%, respectively, from 34% and 29% in the respective prior year periods.
We are focusing our efforts on our key products, which are included in the DBM and Hybrid/Synthetic Segments. In doing so, more resources are being allocated to these segments resulting in lower costs and expenses being allocated to other products.
Costs and expenses associated with Corporate declined 16% and 3% for the three and nine months ended September 30, 2008, respectively, compared to the same periods last year. In both 2008 periods, higher research and development expense were offset by lower performance compensation expense and, in the nine months ended September 30, 2007, we incurred a litigation settlement of $1.1 million. Other Income (Expense)
Other expenses in the third quarter of 2008 of $.5 million is principally the result of foreign exchange losses of $.3 million and $.4 million in interest expense associated with our capital lease obligation offset partially by interest income of $.1. In the third quarter of 2007, other expense primarily represented interest expense of $.4 million related to our capital lease obligation and foreign exchange losses of $.2 million, which were partially offset by interest income of $2 million. Other income in the nine months ended September 30, 2008 of $.2 million is primarily the result of a litigation settlement of $1.0 million in the second quarter of 2008 and interest income of $.4 million partially offset by interest expense of $1.2 million and foreign exchange losses of $.1 million. In the nine months ended September 30, 2007, interest expenses of $.8 million associated with our capital lease obligation, and foreign exchange losses of $.3 million were only partially offset by interest income of $.8 million and a $.1 million gain from a contingent consideration payment related to the sale in 2002 of a foreign subsidiary. Income Tax Provision
For the nine months ended September 30, 2008, after the application of available net operating loss carryforwards, we provided for Federal taxes based on the alternative minimum tax method, certain state taxes on alternative bases and a charge related to the assessment of uncertain tax positions as a result of the ongoing Federal and state tax audits. We continue not to recognize any Federal, state and certain foreign tax benefits, which were subject to full valuation allowances in accordance with the Financial Accounting Standards Board ("FASB") Statement of Financial Accounting Standard ("SFAS") No. 109, "Accounting for Income Taxes." We intend to maintain the valuation allowances until sufficient positive evidence exists to support the reversal of the valuation allowances. We evaluate our position with respect to the valuation allowances each quarter by taking into consideration numerous factors, including, but not limited to: past, present and forecasted results; the impact in each jurisdiction of operating activities; and the anticipated effects of our strategic plan.

We file U.S., state, and foreign income tax returns in jurisdictions with varying statutes of limitations. The 2003 through 2007 tax years generally remain subject to examination by Federal, foreign and most state authorities including, but not limited to, the United States, France, Bulgaria and the State of New Jersey. Our 2003 through 2005 Federal tax returns are currently under examination by the U.S. Internal Revenue Service ("IRS") and the State of New Jersey is examining certain of our 2003 to 2007 state tax filings. The components of our unrecognized tax benefits ("UTBs") are substantially comprised of deferred tax assets which are subject to a full valuation allowance. To the extent we prevail in matters for which either a receivable or a liability for a UTB has been established, are required to pay an amount or utilize net operating loss carryforwards to settle a tax liability, or estimates a change to a specific UTB, our effective tax rate in a given financial reporting period may be affected.
During the nine months ended September 30, 2008, the total amount of our UTBs declined $1.6 million to $2.1 million. It is expected that the amount of UTBs may change in the next twelve months due to our filing of amended Federal and state tax returns, resolution of the revenue authority examinations and expiring statutes of limitation and audit activity. Liquidity and Capital Resources
At September 30, 2008, we had cash and cash equivalents of $19.3 million compared to $22.8 million at December 31, 2007. Working capital declined to $55.9 million at September 30, 2008 compared to $57.9 million at December 31, 2007. The decline in working capital during the nine months ended September 30, 2008, resulted primarily from the use of a portion of available cash to invest in additional long-term allograft bone tissue inventories and capital expenditures.
Net cash provided by operating activities was $2.4 million in the nine months ended September 30, 2008 compared to $3.9 million provided by operating activities in the comparable prior year period. The decrease resulted primarily from increases in accounts receivable related primarily to larger orders as a result of increased revenue from international customers who generally have longer payment terms, an increased investment in unprocessed tissue of $6.3 million and an aggregate increase of $1.2 million in work-in-process and finished goods.
Net cash used in investing activities was $5.6 million and $1.7 million for the nine months ended September 30, 2008 and 2007, respectively. During the nine months ended September 30, 2008, net cash used in investing activity principally relates to the funding of capital expenditures, including the implementation of a new enterprise software system, and production equipment and facilities for new products.
Net cash used in financing activities of $.2 million in the nine months ended September 30, 2008 relates primarily to principal payments on our capital lease obligation offset by the proceeds from the exercise of stock options and the sale of common stock pursuant to our employee stock purchase plan. In the nine months ended September 30, 2007, proceeds received from the exercise of stock options and the sale of common stock pursuant to our employee stock purchase plan were partially offset by payments on our capital lease obligation resulting in net cash provided by financing activities of $.7 million.
Based on our current projections, we believe that our currently available cash and cash equivalents and anticipated future cash flow from operations will be sufficient to meet our forecasted cash needs for the next twelve months. We may seek additional funding to meet the needs of our long-term strategic plans, although we can provide no assurance that such additional funds will be available, or if available, that such funds will be available on favorable terms.
Recent Accounting Developments
On January 1, 2008, we adopted the effective provisions of FASB SFAS No. 157, "Fair Value Measurements" ("SFAS No. 157"), which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS No. 157 applies under a number of other accounting pronouncements that require or permit fair value measurements. Certain provisions of SFAS No. 157, as they relate to non-financial assets and liabilities, are effective for us beginning in January 1, 2009.

Fair value is defined under SFAS No. 157 as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Valuation techniques used to measure fair value under SFAS No. 157 must maximize the use of observable inputs. The standard describes a fair value hierarchy based on the following three levels of inputs that may be used to measure fair value, of which, the first two are considered observable and the last unobservable
• Level 1 - Quoted prices in active markets for identical assets or liabilities.

• Level 2 - Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities.

• Level 3 - Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities.

We adopted SFAS No. 157 for financial assets and liabilities. The adoption of SFAS No. 157 had no impact on our consolidated results of operations and financial condition. At September 30, 2008, we held $5.4 million in money market funds which are valued in accordance with Level 1 and are included in cash and cash equivalents.
In March 2008, the FASB issued SFAS No. 161, "Disclosures about Derivative Instruments and Hedging Activities, an amendment of SFAS No. 133" ("SFAS No. 161"). SFAS No. 161 is effective for us beginning January 1, 2009 and changes the disclosure requirements for derivative instruments and hedging activities. We presently do not have derivative instruments nor do we participate in hedging activities.
Contractual Obligations
As of September 30, 2008, there were no material changes in our contractual obligations from that disclosed in Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" in our Annual Report on Form 10-K for the year ended December 31, 2007.
Impact of Inflation and Foreign Currency Exchange Fluctuations Results of operations for the periods discussed above have not been materially impacted by inflation.
Generally, our results of operations are negatively impacted by a strengthening in the U.S. dollar/euro exchange rate. For the nine months ended September 30, 2008, the U.S. dollar/euro exchange rate strengthen by approximately 3.7% resulting in our incurring a loss of $.1 million on transactions denominated in foreign currencies, and $.1 million on the translation of our non-U.S. operations' financial statements to U.S. dollars. For the three months ended September 30, 2008, a period in which the U.S. dollar strengthened by 11.9%, transaction and translation losses incurred were $.3 million and $.4 million, respectively.
Litigation
We are involved in various legal proceedings. For a discussion of these matters, see Note 14 of "Notes to Consolidated Financial Statements" and ITEM 3. LEGAL PROCEEDINGS both of which are in our Annual Report on Form 10-K for the year ended December 31, 2007. There were no material developments that occurred during the nine months ended September 30, 2008 in the lawsuits reported in the Company's Annual Report on Form 10-K for the year ended December 31, 2007. We are not aware of any other material matters or legal proceedings initiated against us during the first nine months of 2008.
It is possible that our results of operations or liquidity and capital resources could be adversely affected by the ultimate outcome of pending litigation or as a result of the costs of contesting such lawsuits.