The following discussions should be read in conjunction with the condensed consolidated financial statements and notes thereto appearing elsewhere in this Quarterly Report on Form 10-Q.
Information included herein contains "forward-looking statements" which can be identified by the use of forward-looking terminology such as "believes," "expects," "may," "will," "should," or "anticipates" or the negative thereof or variations thereon or comparable terminology, or by discussions of strategy. No assurance can be given that the future results covered by the forward-looking statements will be achieved. Some of the matters set forth in Item 1A, "Risk Factors," of our Annual Report on Form 10-K for the year ended December 31, 2008 constitute cautionary statements identifying factors with respect to such forward-looking statements, including certain risks and uncertainties, that could cause actual results to vary materially from the future results indicated in such forward-looking statements. Other factors could also cause actual results to vary materially from the future results indicated in such forward-looking statements. Except as may be required by law, we undertake no obligation to update any forward-looking statement to reflect events after the date of this report.
FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2009 AND 2008
Results of Operations
Critical Accounting Policies and Estimates The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate the estimates and may adjust them based upon the latest information available. These estimates generally include those related to product returns, bad debts, inventories including purchase commitments, deferred processing costs including reserves for rework, excess and obsolescence, long-lived assets, asset retirement obligations, income taxes, stock-based compensation, contingencies and litigation. We base the 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 value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates. Our accounting practices are discussed in more detail in "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, 2008 as well as in "Recent Accounting Developments" included elsewhere herein. There have been no significant modifications in our critical accounting policies or estimates since December 31, 2008.

Net Income (Loss)

                                           Three Months Ended                     Six Months Ended
(dollars in thousands, except per               June 30,                              June 30,
share amounts)                        2009        2008        Change        2009        2008        Change
Net income (loss)                   $ (1,204 )   $ 1,746     $ (2,950 )   $ (3,000 )   $ 2,554     $ (5,554 )
Earnings (loss) per share:
Basic                               $   (.07 )   $   .10                  $   (.17 )   $   .14
Diluted                             $   (.07 )   $   .10                  $   (.17 )   $   .14

We generated a net loss in the second quarter and first half of 2009 compared to net income in the comparable prior year periods. The net losses in both periods were attributable to an expected decline in revenue which has delivered less gross profit and lower gross margins on the remaining revenue streams primarily due to lower production volumes to absorb our fixed cost base. In the second quarter and first half of 2008 we realized income from a litigation settlement of $1.0 million.
Revenue
For the three months ended June 30, 2009, revenue was $23.5 million as compared to $27.6 million for the three months ended June 30, 2008. For the six months ended June 30, 2009, revenue was $47.4 million compared to $55.2 million in the comparable prior year period.

The following table details the components of our revenue for the three and six months ended June 30, 2009 and 2008:

                                        Three Months Ended                                     Six Months Ended
                                             June 30,                                              June 30,
                                                                 Percent                                               Percent
(dollars in thousands)     2009         2008        Change       Change          2009         2008        Change       Change
DBM                      $ 14,808     $ 16,575     $ (1,767 )         (11 )%   $ 28,834     $ 33,541     $ (4,707 )         (14 )%
Hybrid/Synthetic              647          727          (80 )         (11 )%      1,395        1,371           24             2 %
Traditional Tissue          5,443        5,250          193             4 %      10,720       10,360          360             3 %
Spinal Allograft            1,862        2,286         (424 )         (19 )%      3,742        4,536         (794 )         (18 )%
Client Services               255        2,397       (2,142 )         (89 )%      1,888        4,821       (2,933 )         (61 )%
Other                         456          318          138            43 %         823          555          268            48 %

                         $ 23,471     $ 27,553     $ (4,082 )         (15 )%   $ 47,402     $ 55,184     $ (7,782 )         (14 )%

DBM Segment revenue, which consists of revenue from the sale of Grafton® DBM and Xpanse™ Bone Inserts and revenue from the processing of private label DBM, declined 11% and 14% for the three and six months ended June 30, 2009, respectively, as compared to the same period in 2008, primarily as a result of the anticipated loss in revenue from the temporary suspension of distributing tissue recovered by our Bulgarian subsidiary and a decline in domestic unit sales volume. Revenue from Grafton® DBM and Xpanse™ Bone Inserts and revenue from private label DBM tissue forms declined 9% and 29%, respectively, in the second quarter of 2009 compared to the second quarter of 2008 and 12% and 37%, respectively, in the first half of 2009 compared to the prior year period, primarily as a result of competitive pricing and lower unit sales volume. Revenue in the Hybrid/Synthetic Segment, represented sales of our Plexur Biocomposites and GraftCage® Spacers, declined 11% in the second quarter of 2009 as compared to the same period in 2008 as a result of a decline in revenue from the GraftCage® Spacers. For the first half of 2009, increased Plexur P® revenue offset a decline in revenue from GraftCage® Spacers resulting in a 2% increase over revenue in the comparable prior year period.
Traditional Tissue Segment revenue generated from the worldwide distribution of allograft bone tissue grafts increased 4% and 3%, respectively, in the second quarter and first half of 2009 as compared to the same periods in 2008. The increase in 2009 traditional tissue revenues resulted from increased domestic unit sales volume.
Revenue in the Spinal Allograft Segment declined 19% and 18%, respectively, in the second quarter and first half of 2009 as compared to the same periods in 2008 primarily due to a decrease in domestic unit sales volume. We anticipate continued competitive challenges for our spinal allografts in 2009. Client Services Segment revenue, which is generated by the processing of allograft bone tissue for our clients, declined 89% and 61%, respectively, in the second quarter and first half of 2009 as compared to the same periods in 2008. The revenue generated in 2009 relates mainly to the winding down of our relationship with Musculoskeletal Transplant Foundation ("MTF") as our contractual agreements expired at the end of 2008.
For the three and six months ended June 30, 2009, no customer accounted for more than 10% of revenue. For the three and six months ended June 30, 2008, MTF accounted for 13% and 14% of revenue, respectively.

Gross Profit Margin

                                     Three Months Ended          Six Months Ended
                                          June 30,                   June 30,
          (dollars in thousands)      2009          2008         2009         2008

In the second quarter and first half of 2009, gross margin declined from gross margin in the comparable prior year periods, primarily due to lower revenue, the recording of certain reserves for our tissue inventories, increased pricing pressures, and a slight change in the mix of our revenue.

Operating Expenses

                                       Three Months Ended                                    Six Months Ended
                                            June 30,                                             June 30,
                                                                Percent                                              Percent
(dollars in thousands)     2009         2008       Change       Change          2009         2008       Change       Change
Marketing, selling and
general and
administrative           $ 10,768     $ 11,323     $  (555 )          (5 )%   $ 22,386     $ 23,003     $  (617 )          (3 )%
Research and
development                 1,998        1,774         224            13 %       3,651        3,534         117             3 %

Total                    $ 12,766     $ 13,097     $  (331 )          (3 )%   $ 26,037     $ 26,537     $  (500 )          (2 )%

Marketing, selling and general and administrative expenses declined in the second quarter and first half of 2009 when compared to the prior year periods. Generally, we had higher sales and marketing costs which were offset by lower performance-based compensation costs and professional fees. In the second quarter and first half of 2009, research and development expenses increased 13% and 3%, respectively, as compared to the same periods in 2008, primarily due to an increase in staffing. We anticipate that our quarterly research and development expenditures for the remainder of 2009 will decline from the second quarter level as several new tissue products have moved from development to commercialization.
Operating Income (Loss) By Segment

                                           Three Months Ended                                          Six Months Ended
                                                June 30,                                                   June 30,
                                                                      Percent                                                    Percent
(dollars in thousands)       2009          2008         Change        Change           2009           2008          Change        Change
DBM                        $  3,768      $  5,102      $ (1,334 )          (26 )%    $   7,700      $  11,083      $ (3,383 )         (31 )%
Hybrid/Synthetic               (234 )          66          (300 )         (455 )%         (132 )         (106 )         (26 )         (25 )%
Traditional Tissue              778           670           108             16 %         1,068          1,526          (458 )         (30 )%
Spinal Allograft                307           254            53             21 %           551             16           535         3,344 %
Client Services                 (68 )       1,617        (1,685 )         (104 )%        1,125          3,046        (1,921 )         (63 )%
Other Product Lines             209           230           (21 )           (9 )%           80            462          (382 )         (83 )%

                              4,760         7,939        (3,179 )          (40 )%       10,392         16,027        (5,635 )         (35 )%
Corporate                    (5,995 )      (6,534 )         539             (8 )%      (12,931 )      (13,820 )         889            (6 )%

Operating Income (Loss)    $ (1,235 )    $  1,405      $ (2,640 )         (188 )%    $  (2,539 )    $   2,207      $ (4,746 )        (215 )%

Total product segment operating income for the second quarter and first half of 2009 declined as compared to the comparable prior year periods principally due to lower gross profit as a result of the decline in revenues and higher selling expenses. In the second quarter and first half of 2009, product segment operating income, as a percent of revenue, declined to 20% and 22%, respectively, compared to 29% in both comparable prior year periods. Costs and expenses associated with Corporate declined in both the three and six months ended June 30, 2009 from the comparable prior year periods primarily due to lower performance based compensation and professional fees. Other Income (Expense)
In the second quarter and first half of 2009, other expense of $0.2 million and $0.7 million, respectively, primarily represented primarily by interest expense associated with our capital lease obligation offset partially by foreign exchange gains. Interest income on our invested cash balances was not significant.
Other income in the second quarter of 2008 of $0.7 million is principally the result of proceeds from a litigation settlement of $1.0 million and interest income of $0.1 million on invested cash balances, partially offset by $0.4 million in interest expense associated with our capital lease obligation. Other income in the first half of 2008 of $0.7 million was primarily the result of the litigation settlement of $1.0 million, interest income of $0.3 million and foreign exchange gains of $0.2 million, principally on intercompany debt, which were partially offset by interest expense of $0.8 million.

Income Tax Provision
For the three months ended March 31, 2009, after the application of available net operating loss carryforwards, we provided for Federal taxes based on the alternative minimum tax method, as well as recorded a provision for certain minimum state taxes. During the three months ended June 30, 2009, certain unrecognized tax positions were effectively settled resulting in the recognition of a $0.3 million tax benefit. We continue not to recognize any Federal, state and certain foreign tax benefits, which were subject to full valuation allowances in accordance with Financial Accounting Standards Board Statement of Financial Accounting Standard No. 109, "Accounting for Income Taxes." We intend to maintain the valuation allowances until sufficient positive evidence exists to support the reversal of a valuation allowance that we have established. 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 2004 Federal tax returns are currently under examination by the U.S. Internal Revenue Service ("IRS"). The State of New Jersey is examining certain of the Company's 2003 through 2007 state tax filings and an audit of our 2006 and 2007 tax filings by our French subsidiary has recently commenced.
We have reached a tentative agreement with the IRS regarding the audit of the Company's Federal tax returns, which is subject to review and approval by the Joint Committee on Taxation. Pending receipt of the Joint Committee on Taxation report, the State of New Jersey has completed its review of our filings. The tentative agreement with the IRS results in us owing no additional Federal or State of New Jersey tax and the aggregate amount of our available Federal and State of New Jersey net operating loss carryforwards will not be materially impacted as a result of either audit although certain Federal research and development credit carryforwards will be eliminated. Any remaining items disallowed would be deductible in future periods. Until such time as Joint Committee on Taxation approval is received, the IRS and State of New Jersey examinations will not be closed or effectively settled for financial reporting purposes.
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 and/or utilize net operating losses ("NOLs") to settle a tax liability or estimates regarding a UTB change as a result of changes in facts and circumstances, our effective tax rate in a given financial reporting period may be affected. Subsequent to December 31, 2008, mainly because of the settlement of certain prior year unrecognized tax positions, our gross UTB declined by $2.5 million to $1.5 million. It is expected that the amount of UTBs will change in the next twelve months due to our filing amended Federal and state tax returns, resolution of the revenue authority examinations and expiring statutes of limitation and audit activity; however, we do not anticipate the change, if any, to be significant.
Liquidity and Capital Resources

                                           June 30,       December 31,
               (dollars in thousands)        2009             2008
               Cash and cash equivalents   $  11,799     $       18,823
               Working Capital             $  57,333     $       55,624
               Stockholders' equity        $  80,626     $       82,850



                                                            Six Months Ended
                                                                June 30,
      Summary of our cash flow:                             2009         2008
      Net cash (used in) operating activities             $ (5,334 )   $   (100 )
      Net cash (used in) investing activities             $ (1,208 )   $ (3,573 )
      Net cash (used in) financing activities             $   (491 )   $    (27 )
      Effect of foreign currency exchange rates on cash   $      9     $     51

      Net decrease in cash and cash equivalents           $ (7,024 )   $ (3,649 )

Cash Flow From Operating Activities
Net cash used by operating activities was $5.3 million in the first half of 2009 compared to $0.1 million used by operating activities in the first half of 2008. The change resulted primarily from a net loss in the first half of 2009 compared to a profit in the prior year period and an increase in accounts receivable as a result of more of our customers managing their internal cash position due to the current economic downturn. During the first half of 2009, we increased our investment in unprocessed tissue and work-in-process by $3.4 million and $2.7 million, respectively, which was partially offset by a $3.3 million decline in finished goods.
Cash Flow From Investing Activities
Net cash used in investing activities was $1.2 million and $3.6 million for the six months ended June 30, 2009 and 2008, respectively, and principally relates to funding of capital expenditures and intellectual property. We anticipate that for the balance of 2009 funding of capital expenditures and patent development will be below our 2008 levels.
Cash Flow From Financing Activities
Net cash used in financing activities of $0.5 million in the six months ended June 30, 2009 primarily relates to principal payments on our capital lease obligation of $0.4 million, our purchase of our own common stock under a repurchase program approved by our Board of Directors in December 2008, partially offset by the proceeds from the exercise of stock options and the sale of common stock pursuant to our employee stock purchase plan. In 2008, proceeds of $0.4 million from the exercise of stock options and the sale of common stock pursuant to our employee stock purchase plan were offset by payments of $0.4 million on our capital lease obligation. Financing Needs
Based on our current projections and estimates, 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. We can provide no assurance that such additional funds will be available, or if available, that such funds will be available on favorable terms.
Repurchase of Common Stock
In December 2008, our Board of Directors authorized a stock repurchase program under which up to $5.0 million of shares of our common stock may be acquired. Stock repurchases may be executed from time to time at current market prices through open-market and privately negotiated transactions in such amounts as management deems appropriate. The final number of shares repurchased will depend on a variety of factors, including the level of our cash and cash equivalents, price, corporate and regulatory requirements and other market conditions. The repurchase program may be terminated at any time without prior notice. During the first quarter of 2009 we repurchased 50,480 shares with an average price paid of $2.02 per share. We made no repurchases in the second quarter of 2009. Through June 30, 2009, we had acquired 115,670 shares of our common stock at an average purchase price of $1.96 per share. Recent Accounting Developments
For information on new accounting standards, refer to Note 1, Recent Accounting Pronouncements, in "Notes to Unaudited Condensed Consolidated Financial Statements" included elsewhere herein.
Contractual Obligations
As of June 30, 2009, 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, 2008.
Impact of Inflation and Foreign Currency Exchange Fluctuations The results of operations for the periods discussed have not been materially affected by inflation. We are subject to foreign currency fluctuations for material changes in exchange rates between the U.S. dollar and the euro. To the extent our foreign source revenue grows and represents a larger percentage of our consolidated revenues and profits, foreign currency translation adjustments may impact our operating results to a greater extent.

During the first half of 2009, the U.S. dollar remained flat against the euro whereas in the same period in the prior year the euro strengthened against the U.S. dollar. This change resulted in our recording a minimal transaction/translation foreign exchange gain in the first half of 2009 compared to a gain in the first half of 2008 of $0.2 million. Litigation
Osteotech is 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 in our Annual Report on Form 10-K for the year ended December 31, 2008. There were no material developments that occurred during the three months ended June 30, 2009 in the lawsuits reported in the Company's Annual Report on Form 10-K for the year ended December 31, 2008. We are not aware of any other material matters or legal proceedings initiated against us during the first six months of 2009.
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. Government Proceedings
In December 2008, we were advised that during a November 2008 inspection of donor recovery sites in Bulgaria by the French regulatory agency, afssaps, deficiencies were identified. As a precautionary measure, we temporarily suspended the distribution of allograft tissue grafts processed from tissue recovered by our subsidiary, TB OsteoCentre Bulgaria EAD ("OCBG"). This action was not due to product contamination or to any deficiencies with the tissue grafts. At June 30, 2009, approximately $6,900 in processed and unprocessed tissue remained subject to our self-imposed suspension of shipments. In July 2009, we received notice from afssaps which allowed us to lift our self-imposed temporary suspension and immediately begin processing and distributing tissue recovered by OCBG. We will be releasing finished OCBG related allograft tissue grafts following a process agreed to with afssaps and in accordance with our procedure. At the conclusion of the initial phase of this process, we will need to complete additional procedures to release a remaining $600 in tissue product.