Our management's discussion and analysis of our financial condition and results of operations include the identification of certain trends and other statements that may predict or anticipate future business or financial results that are subject to important factors, such as those set forth in Item 1A "Risk Factors" in our Annual Report on Form 10-K for the year ending December 31, 2008.

Overview

We are a medical technology company focused on the design, development, manufacturing and marketing of products for the surgical treatment of spine disorders, with a focus on products that treat conditions that affect the aging spine. Our broad product portfolio and pipeline includes a variety of spinal disorder products and systems focused on solutions addressing the cervical, thoracolumbar, intervertebral, minimally invasive, vertebral compression fracture, osteoporotic bone, and spinal stenosis markets. Our principal product offerings are focused on the market for orthopedic spinal disorder solution products, which is estimated in the U.S. to be approximately $5.8 billion in revenue in 2008 and is expected to grow more than 10% annually over the next three years. Our "surgeons' culture" emphasizes collaboration with spinal surgeons to conceptualize, design and co-develop a broad range of products. We have a state-of-the-art, in-house manufacturing facility that provides us with a unique competitive advantage, and enables us to rapidly deliver solutions to meet surgeons' and patients' critical needs. Our products and systems are made of titanium, titanium alloy, stainless steel and a strong, heat resistant, radiolucent, biocompatible plastic called polyetheretherketone, or PEEK. We also sell products made of allograft, a precision-milled and processed human bone that surgeons can use in place of metal and synthetic materials. We also sell bone-grafting products that are comprised of both tissue-based and synthetic materials. We believe that our products and systems have enhanced features and benefits that make them attractive to surgeons and that our broad portfolio of products and systems provide a comprehensive solution for the safe and successful surgical treatment of spine disorders. All of our implants that are sold in the U.S. have been cleared by the FDA and these products have been used in over 10,700 and 8,600 spine disorder surgeries in 2008 and 2007, respectively. In addition to selling our products in the U.S., we also sell our products in Japan, the European Union and Hong Kong.

Although our products generally are purchased by hospitals and surgical centers, orders are typically placed at the request of surgeons who then use our products in a surgical procedure. During the three months ended March 31, 2009 and 2008, no single surgeon, hospital or surgical center represented greater than 10% of our consolidated revenues. Additionally, we sell a broad array of products, which diminishes our reliance on any single product or spine disorder.

In 2007, as part of our strategy to focus on disorders affecting the aging spine, we began entering into license agreements with third parties that we believe will enable us to rapidly develop and commercialize unique products for the treatment of spinal disorders that disproportionately affect the aging population. Through March 31, 2009, we licensed or acquired approximately 40 patent and patent applications from third parties. A discussion of our license agreements through December 31, 2008 may be found in "Item 1-Business-Intellectual Property" included in our Annual Report on Form 10-K for the year ending December 31, 2008.

To assist us in evaluating our product development strategy, we regularly monitor long-term technology trends in the spinal implant industry. Additionally, we consider the information obtained from discussions with the surgeon community and our Scientific Advisory Board in connection with the demand for our products, including potential new product launches. We also use this information to help determine our competitive position in the spinal implant industry and the capacity requirements of our manufacturing facility.

Revenue and Expense Components

The following is a description of the primary components of our revenues and expenses:

Revenues. We derive our revenues primarily from the sale of spinal surgery implants used in the treatment of spine disorders. Spinal implant products include spine screw systems, vertebral body replacement devices, plates and bone grafting materials. Our revenues are generated by our direct sales force and independent distributors. Our products are ordered directly by surgeons and shipped and billed to hospitals or surgical centers. In Japan, where orthopedic trauma surgeons also perform spine surgeries, we have sold and will continue to sell orthopedic trauma products in order to introduce our spine products to Japanese surgeons. In Europe, we use independent distributors that purchase our products and market them to their surgeon customers. As a result of offering payment terms greater than our customary U.S. business terms and operating in a new market in which we have no prior experience, revenues for sales to our European distributors have been deferred until payments become due or cash is received.

Cost of revenues. Cost of revenues consists of direct product costs, royalties, depreciation of our surgical instruments, and the amortization of purchased intangibles. We manufacture substantially all of the non-allograft implants that we sell. Our product costs consist primarily of direct labor, manufacturing overhead, raw materials and components. Allograft product costs include the cost of procurement and processing of human tissue. We incur royalties related to technology we license from others and products developed in part by surgeons with whom we collaborate in the product development. Amortization of purchased intangibles consists of amortization of developed product technology.

Research and development. Research and development expense consists of costs associated with the design, development, testing, and enhancement of our products. Research and development costs also include salaries and related employee benefits, research-related overhead expenses, fees paid to external service providers, and costs associated with our Scientific Advisory Board and Executive Surgeon Panels.

In-process research and development. In-process research and development, or IPR&D, consists of acquired research and development assets that were not technologically feasible on the date we acquired worldwide licenses for technology related to the dynamic cervical plate and the expandable interbody products and had no alternative future use at that date. At the time of acquisition, we expect all acquired IPR&D will reach technological feasibility, but there can be no assurance that commercial viability of a product will be achieved. The nature of the efforts to develop the acquired technologies into commercially viable products consists principally of planning, designing, and obtaining regulatory clearances. The risks associated with achieving commercialization include, but are not limited to, delays or failures during the development process, delays or failures to obtain regulatory clearances, and intellectual property rights of third parties.

Sales and marketing. Sales and marketing expense consists primarily of salaries and related employee benefits, sales commissions and support costs, professional service fees, travel, medical education, trade show and marketing costs.

General and administrative. General and administrative expense consists primarily of salaries and related employee benefits, professional service fees and legal costs.

Litigation settlement. Litigation settlement expense consists of material settlements of lawsuits.

Total other income (expense). Total other income (expense) includes interest income, interest expense, gains and losses from foreign currency exchanges and other non-operating gains and losses.

Income tax provision. Income tax expense consists primarily of state and foreign income taxes and the tax effect of changes in deferred tax liabilities associated with tax goodwill.

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the U.S. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosures. On an on-going basis, we evaluate our estimates and assumptions, including those related to revenue recognition, allowances for accounts receivable, inventories, goodwill and intangible assets, stock-based compensation and income taxes. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions conditions.

Critical accounting policies are those that, in management's view, are most important in the portrayal of our financial condition and results of operations. Management believes there have been no material changes during the three months ended March 31, 2009 to the critical accounting policies discussed in the Management's Discussion and Analysis of Financial Condition and Results of Operations section of our Annual Report on Form 10-K for the year ended December 31, 2008, as filed with the SEC on March 4, 2009.

Results of Operations

The table below sets forth certain statements of operations data expressed as a
percentage of revenues for the periods indicated. Our historical results are not
necessarily indicative of the operating results that may be expected in the
future.



                                              Three Months Ended March 31,
                                               2009                  2008
      Revenue                                     100.0 %               100.0 %
      Cost of revenues                             35.4                  34.0

      Gross profit                                 64.6                  66.0
      Operating expenses:
      Research and development                      9.4                  13.8
      In-process research and development           4.2                   5.6
      Sales and marketing                          41.7                  43.6
      General and administrative                   19.5                  24.0
      Litigation settlement                          -                   47.4

      Total operating expenses                     74.8                 134.4

      Operating loss                              (10.2 )               (68.4 )

      Other income (expense):
      Interest income                               0.1                   0.9
      Interest expense                             (3.0 )                (0.8 )
      Other income (expense), net                  (0.8 )                 0.7

      Total other income (expense)                 (3.7 )                 0.8

      Loss before taxes                           (13.9 )               (67.6 )
      Income tax provision                          0.4                   0.4

      Net loss                                    (14.3 )%              (68.0 )%

Reclassification

Certain prior year balances have been reclassified in the accompanying condensed consolidated financial statements to conform to the current year presentation. In our Quarterly Report on Form 10-Q for the three months ended March 31, 2008 filed with the SEC on May 12, 2008, our operating expenses in Japan were classified as general and administrative expenses. In this Quarterly Report on Form 10-Q, we separated the Japanese sales and marketing expenses from the general and administrative expenses. This reclassification has no impact upon total operating expenses and net loss, and resulted in a reclassification of $1.0 million of general and administrative expense to sales and marketing expense for the three months ended March 31, 2008.

Three Months Ended March 31, 2009 Compared to the Three Months Ended March 31, 2008

Revenues. Revenues were $30.6 million for the three months ended March 31, 2009 compared to $23.2 million for the three months ended March 31, 2008, representing an increase of $7.4 million, or 32.0%. U.S. revenues increased $5.1 million primarily due to increased sales of our Zodiac, Novel, Trestle, Biologics and Solanas product lines, partially offset by a decrease in our Reveal product line. In addition, Asia revenues increased $1.3 million due to both sales volumes and the foreign currency exchange rate. We commenced sales in Europe in the third quarter of 2008. We recognized revenue of $1.0 million in European sales in the three months ended March 31, 2009.

Cost of revenues. Cost of revenues were $10.8 million for the three months ended March 31, 2009 compared to $7.9 million for the three months ended March 31, 2008, representing an increase of $2.9 million, or 37.3%. The increase was primarily due to $1.3 million in higher product costs associated with increased revenue performance, increased royalty payments of $1.0 million due to increased sales volume and the new royalty payments made in connection with the Biedermann/DePuy litigation settlement, as disclosed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2008 filed with the SEC on March 4, 2009, and increased depreciation costs of $0.7 million based on a larger installed surgical instruments asset base capitalized during 2009.

Gross profit. Gross profit was $19.8 million for the three months ended March 31, 2009 compared to $15.3 million for the three months ended March 31, 2008, representing an increase of $4.5 million, or 29.2%. Gross margin of 64.6% of revenues for the three months ended March 31, 2009 decreased 1.4 percentage points from the three months ended March 31, 2008. The 1.4 percentage point decrease was primarily due to increased royalty payments of 1.9 percentage points and increased instrument depreciation of 1.9 percentage points, offset by a decrease of 1.0 percentage points related to amortization of intangibles and 1.4 percentage points related to improved manufacturing efficiencies.

Research and development. Research and development expenses were $2.9 million for the three months ended March 31, 2009 compared to $3.2 million for the three months ended March 31, 2008, representing a decrease of $0.3 million, or 10.5%. The decrease was primarily due to decreases in outsourced prototype and other development activities.

In-process research and development. In-process research and development expenses were $1.3 million for the three months ended March 31, 2009 compared to $1.3 million for the three months ended March 31, 2008, representing substantially no change. In the three months ended March 31, 2009, we incurred costs related to our acquisition of technology related to a stand-alone interbody device of $0.5 million, $0.6 million related to our acquisition of technology related to a device for the treatment of spinal stenosis ($0.25 million in cash and $0.35 million in stock (174,129 shares)), and $0.2 million combined for three smaller in-process research and development collaborations with third parties. In the three months ended March 31, 2008, we incurred costs for the licenses for the technology related to the expandable VBR license of $1.0 million and a dynamic cervical plate of $0.3 million.

Sales and marketing. Sales and marketing expenses were $12.8 million for the three months ended March 31, 2009 compared to $10.1 million for the three months ended March 31, 2008, representing an increase of $2.7 million, or 26.5%. The increase was primarily due to higher commission expense of $1.8 million due to the higher sales volume and an increase of $0.9 million in Asia as we increase our product mix towards Alphatec's spinal products.

General and administrative. General and administrative expenses were $6.0 million for the three months ended March 31, 2009 compared to $5.6 million for the three months ended March 31, 2008, representing an increase of $0.4 million, or 7.2%. The increase was primarily due to an increase in legal fees, as well as fees and expenses related to the prosecution of our patent portfolio.

Litigation Settlement. Litigation settlement was $11.0 million for the three months ended March 31, 2008. The expense was due to a settlement agreement we entered into in May 2008 with Biedermann and DePuy, and the corresponding one-time settlement payment. This one-time settlement payment was paid in May 2008. There was no corresponding litigation settlement expense during the three months ended March 31, 2009.

Interest Income. Interest income was $0 for the three months ended March 31, 2009 compared to $0.2 million for the three months ended March 31, 2008, representing a decrease of $0.2 million, or 83.1%. The decrease was primarily due to lower cash and cash equivalent balances as a result of the cash used in operating activities.

Interest Expense. Interest expense was $0.9 million for the three months ended March 31, 2009 compared to $0.2 million for the three months ended March 31, 2008, representing an increase of $0.7 million, or 414.6%. The increase was primarily due to increased interest expense for our loan agreement and line of credit with Silicon Valley Bank and Oxford Finance Corporation. We repaid our line of credit with General Electric Capital Corporation in the fourth quarter of 2008.

Other income (expense), net. Other income (expense), net was $(0.3) million for the three months ended March 31, 2009 compared to $0.1 million for the three months ended March 31, 2008, representing a decrease in income of $0.4 million or 272.8%. The decrease was due to greater foreign currency exchange losses realized in 2009 as compared to 2008.

Income tax provision. Income tax provision was $0.1 million for the three months ended March 31, 2009 compared to $0.1 million for the three months ended March 31, 2008, representing substantially no change. The U.S. income tax expense consists primarily of state income taxes and the tax effect of changes in deferred tax liabilities associated with tax deductible goodwill. The foreign income tax expense consists primarily of Japanese provincial and city income taxes.

Liquidity and Capital Resources

At March 31, 2009, our principal sources of liquidity consisted of cash and cash equivalents of $10.1 million, accounts receivable, net of $23.8 million, and remaining amounts available under our credit facilities of $2.1 million. We believe such amounts will be sufficient to fund our projected operating requirements through at least March 31, 2010. We will need to invest in working capital and capitalized surgical instruments in order to support our revenue projections through 2009. Should we not be able to achieve our revenue forecast and customer collections, and cash consumption starts to exceed forecasted consumption, management will need to adjust our investment in surgical instruments and manage our inventory to the decreased sales volumes. If management does not make these adjustments in a timely manner, there could be an adverse impact on our financial resources.

Historically, our principal sources of cash have included customer payments from the sale of our products, proceeds from the issuance of common and preferred stock and proceeds from the issuance of debt. Our principal uses of cash have included cash used in operations, acquisitions of businesses and intellectual property rights, payments relating to purchases of property and equipment and repayments of borrowings. We expect that our principal uses of cash in the future will be for operations, working capital, capital expenditures, and potential acquisitions. We expect that, as our revenues grow, our sales and marketing and research and development expenses will continue to grow and, as a result, we will need to generate significant net revenues to achieve profitability. We believe that our current cash and cash equivalents, revenues from our operations, and our ability to draw down on secured credit facilities will be sufficient to fund our projected operating requirements including potential R&D license milestone obligations through at least April 1, 2010. If we believe it is in our interest to raise additional funds, we may seek to sell additional equity or debt securities or

borrow additional money. The sale of additional equity or convertible debt securities could result in dilution to our stockholders. If additional funds are raised through the issuance of equity or debt securities, these securities could have rights senior to those associated with our common stock and could contain covenants that would restrict our operations. Any additional financing may not be available in amounts or on terms acceptable to us, or at all. If we are unable to obtain this additional financing, we may be required to reduce the scope of our planned product development and marketing efforts.

As of March 31, 2009, we had $10.1 million in cash and cash equivalents. A substantial portion of our available cash funds is in business accounts with reputable financial institutions. However, our deposits, at times, may exceed federally insured limits. The capital markets have recently been highly volatile and there has been a lack of liquidity for certain financial instruments, especially those with exposure to mortgage-backed securities and auction rate securities. This lack of liquidity has made it difficult for the fair value of these types of instruments to be determined. We do not hold any marketable securities as of March 31, 2009.

As a result of recent volatility in the capital markets, the cost and availability of credit has been and may continue to be adversely affected by illiquid credit markets and wider credit spreads. Concern about the stability of the markets generally and the strength of counterparties specifically has led many lenders and institutional investors to reduce, and in some cases, cease to provide funding to borrowers. Continued turbulence in the U.S. and international markets and economies may adversely affect our ability to obtain additional financing on terms acceptable to us, or at all. If these market conditions continue, they may limit our ability to timely replace maturing liabilities and to access the capital markets to meet liquidity needs.

Operating activities

We used net cash of $6.4 million in operating activities for the three months ended March 31, 2009. During this period, net cash used in operating activities primarily consisted of a net loss of $4.4 million, a decrease in working capital and other assets of $5.9 million, primarily due to increases in accounts receivable of $5.4 million and inventory of $3.2 million in support of the higher sales volume, partially offset by increases in accounts payable, accrued expenses and deferred revenues of $3.0 million, and offset by $4.0 million of non-cash costs including amortization, depreciation, deferred income taxes, stock-based compensation, in-process research and development that was purchased using our common stock and interest expense related to amortization of debt discount and issue costs.

Investing activities

We used net cash of $2.5 million in investing activities for the three months ended March 31, 2009 primarily for the purchase of $2.9 million in instruments, computer equipment, leasehold improvements and manufacturing equipment, partially offset by the $0.4 million proceeds from the sale of our prior investment in Noas Medical Company, a Japanese spinal and orthopedic implant distributor.

Financing activities

We generated net cash of $0.8 million from financing activities for the three months ended March 31, 2009. Net proceeds from borrowings under our line of credit totaled $1.4 million. We made a payment on our line of credit and made other principal payments on notes payable and capital lease obligations totaling $0.6 million.

Credit Facility and other debt

In December 2008, we entered into a loan agreement with Silicon Valley Bank and Oxford Finance Corporation, or the Lenders, consisting of a $15.0 million term loan and a $15.0 million working capital line of credit. The term loan carries a fixed interest rate of 11.25% with interest payments due monthly but no principal repayment through September 2009. Thereafter, we will be required to repay the principal plus interest in 30 equal monthly installments, ending in April 2012. An additional finance charge of $0.8 million is due in April 2012. We will pay a prepayment penalty if the loan is repaid prior to maturity. We do not currently anticipate repaying the debt early.

The working capital line of credit carries a variable interest rate equal to the prime rate plus either 2.5% or 2.0%, depending on our financial performance. Interest only payments are due monthly and the principal is due at maturity in April 2012.

In connection with the term loan, we issued warrants to the Lenders to purchase an aggregate of approximately 476,000 shares of our common stock. The warrants are immediately exercisable and have an exercise price of $1.89 per share and a ten year term. We recorded the value of the warrants of $0.9 million as a debt discount.

We are also required to maintain compliance with financial covenants in our Credit Facility, which include a minimum level of revenues and a minimum level of earnings before interest, taxes, depreciation, amortization, and non-cash charges related to equity-based compensation and in-process R&D. The Credit Facility also contains customary affirmative and negative covenants for loan agreements of this type, including, but not limited to, limitations on the incurrence of indebtedness, asset dispositions, acquisitions, investments, dividends and other restricted payments, liens and transactions with affiliates. As of March 31, 2009, we were in compliance with the financial covenants in the Credit Facility. To secure the repayment of any amounts borrowed under the loan agreement, we granted the Lenders a first priority security interest in all of our assets, other than our intellectual property and our rights under license agreements granting us the right to intellectual property. We also agreed not to pledge or otherwise encumber our intellectual property assets without the consent of the Lenders.

The Lenders have the right to declare the loan immediately due and payable in an event of default under the Credit Facility, which includes, among other things, the failure to make payments when due, breaches of representations, warranties or covenants, the occurrence of certain insolvency events, or the occurrence of an event which could have a material adverse effect on us.

During the three months ended March 31, 2009, we repaid $0.5 million and subsequently drew an additional $1.9 million on the working capital line of credit. The balance of the line of credit as of March 31, 2009 was $12.9 million. The balance on the term loan was $14.2 million, net of the debt discount. Amortization of the debt discount and issuance costs and accretion of the additional finance charge, which are recorded to interest expense, totaled $0.3 million for the three months ended March 31, 2009. Interest expense for the Credit Facility, excluding debt discount and issuance cost amortization and . . .