SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

MACROPORE BIOSURGERY, INC.

(Exact name of Registrant as Specified in Its Charter)

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    ý  No   o

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

As of April 30, 2005, there were 14,032,184 shares of the registrant’s common stock outstanding.

MACROPORE BIOSURGERY, INC.

INDEX

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PART I.  FINANCIAL INFORMATION

Item 1.  Financial Statements

Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders
MacroPore Biosurgery, Inc.:

We have reviewed the accompanying consolidated condensed balance sheet of MacroPore Biosurgery, Inc. and subsidiaries as of March 31, 2005, and the related consolidated condensed statements of operations and comprehensive income (loss), and cash flows for the three month periods ended March 31, 2005 and 2004.  These consolidated condensed financial statements are the responsibility of the Company’s management.

We conducted our reviews in accordance with the standards of the Public Company Accounting Oversight Board (United States).  A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters.  It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the financial statements taken as a whole.  Accordingly, we do not express such an opinion.

Based on our reviews, we are not aware of any material modifications that should be made to the consolidated condensed financial statements referred to above for them to be in conformity with U.S. generally accepted accounting principles.

We have previously audited, in accordance with standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of MacroPore Biosurgery, Inc. and subsidiaries as of December 31, 2004, and the related consolidated statements of operations and comprehensive loss, shareholders’ equity, and cash flows for the year then ended (not presented herein); and in our report dated March 11, 2005, we expressed an unqualified opinion on those consolidated financial statements.  In our opinion, the information set forth in the accompanying consolidated condensed balance sheet as of December 31, 2004 is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.

Note 1 of MacroPore Biosurgery, Inc.’s audited financial statements as of December 31, 2004 and for the year then ended, discloses that the Company derives a substantial portion of its revenues from a related party.  Our auditor’s report on those financial statements dated March 11, 2005, includes an explanatory paragraph referring to the matter in note 1 of those financial statements.

San Diego, California
May 6, 2005

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MACROPORE BIOSURGERY, INC.
CONSOLIDATED CONDENSED BALANCE SHEETS

SEE NOTES TO UNAUDITED CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

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MACROPORE BIOSURGERY, INC.
CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)
(UNAUDITED)

SEE NOTES TO UNAUDITED CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

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MACROPORE BIOSURGERY, INC.
CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS
(UNAUDITED)

SEE NOTES TO UNAUDITED CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

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MACROPORE BIOSURGERY, INC.,

NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

MARCH 31, 2005

(UNAUDITED)

1.                 Basis of Presentation

The accompanying unaudited consolidated condensed financial statements as of March 31, 2005 and for the three months ended March 31, 2005 and 2004 have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information.  Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for annual financial statements.  The consolidated condensed balance sheet at December 31, 2004 has been derived from the audited financial statements at that date, but does not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements.  In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation of the financial position and results of operations of MacroPore Biosurgery, Inc. (“MacroPore” or the “Company”) have been included.  Operating results for the three months ended March 31, 2005 are not necessarily indicative of the results that may be expected for the year ending December 31, 2005.  For further information, refer to the consolidated financial statements for the year ended December 31, 2004 and footnotes thereto which were included in the Company’s Annual Report on Form 10-K, dated March 31, 2005.

2.                 Use of Estimates

The preparation of consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions affecting the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the reporting period.  Actual results could differ from these estimates.  Estimates and assumptions are reviewed periodically, and the effects of revisions are reflected in the consolidated financial statements in the periods they are determined to be necessary.

The Company’s most significant estimates and critical accounting policies involve revenue recognition, determining the warranty provision, evaluating for goodwill impairment, and the accounting for product line dispositions.

3.                 Stock Based Compensation

The Company applies the intrinsic value-based method of accounting as prescribed by Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations including Financial Accounting Standards Board (FASB) Interpretation No. 44,  “Accounting for Certain Transactions Involving Stock Compensation-An Interpretation of APB Opinion No. 25” to account for its employee stock option plans.  Under the intrinsic value method, compensation expense is recognized only if the current market price of the underlying stock exceeds the exercise price as of the measurement date (typically the date of grant).  Any resulting expense is recorded on a straight-line basis over the applicable vesting period.  Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation,” established accounting and disclosure requirements using a fair value-based method of accounting for stock-based employee compensation plans.  As permitted by SFAS No. 123, the Company has elected to continue to apply the intrinsic value-based method of accounting described above, and has adopted the disclosure requirements of SFAS No. 123, as amended by SFAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure.”

The pro forma effects of stock-based compensation on net income (loss) and net income (loss) per common share have been estimated using a grant date fair value model (Black-Scholes option-pricing model).

The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options that have no restrictions and are fully transferable and negotiable in a free trading market.  Black-Scholes does not consider the employment, transfer or vesting restrictions that are inherent in the Company’s employee options.  Use of an option valuation model, as required by SFAS No. 123, includes subjective assumptions based on long-term predictions, including the expected stock price volatility and average life of each option grant.  Because the Company’s employee stock options have characteristics different from those of freely traded options, and because the assumptions underlying the Black-Scholes model involve substantial judgment, the Company’s estimate of the fair value of its awarded stock options may differ from the ultimate value realized by the recipient employee.

The Company estimated the weighted average estimated fair values of stock options granted for the three months ended March 31, 2005 and 2004 at $2.28 and $2.36 per share, respectively, on the date of grant.  Fair value under SFAS No. 123 is determined

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using the Black-Scholes option-pricing model with the following assumptions:

Had compensation expense been recognized for stock-based compensation plans in accordance with SFAS No. 123, the Company would have recorded the following net income (loss) and net income (loss) per share amounts:

The pro forma compensation expense may not be representative of such expense in future years.

In December 2004, the FASB issued SFAS No. 123 (revised 2004), “Share-based Payment” (“FAS 123R”).  As amended by Securities and Exchange Commission Release No. 33-8568, “Amendment to Rule 4-01(a) of Regulation S-X Regarding the Compliance Date for Statement of Financial Accounting Standards No. 123 (Revised 2004), Share-Based Payment”, FAS 123R is effective for annual periods beginning after June 15, 2005 (January 1, 2006 for the Company).

FAS 123R will require all share-based payment transactions, including those with employees, to be measured at fair value.  Moreover, the fair value of share-based payment awards (including employee stock option grants) will be recognized as expense in the statements of operations over the requisite service period of each award.  FAS 123R also changes the manner in which deferred taxes are recognized on share-based payment awards, as well as the accounting for award modifications.

The adoption of FAS 123R will have a material effect on the Company’s results of operations.  Based on pro forma amounts for historical periods presented earlier in this note, the Company’s net loss will increase (or its net income would be reduced) each quarterly period once FAS 123R has been adopted.

4.                 Short-term Investments

The Company invests excess cash in highly liquid debt instruments of financial institutions and corporations with strong credit ratings and in United States government obligations.  The Company has established guidelines relative to diversification and maturities that maintain safety and liquidity.  These guidelines are periodically reviewed and modified to take advantage of trends in yields and interest rates.

The Company has evaluated its investments in accordance with the provisions of SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities.”  Based on such evaluation, the Company’s management has determined that all of its investment securities are properly classified as available-for-sale.  Based on the Company’s intent, its investment policies and its ability to liquidate debt securities, the Company classifies such short-term investment securities within current assets.  Available-for-sale securities are carried at fair value, with unrealized gains and losses reported as a separate component of Stockholders’ Equity as accumulated other comprehensive income (loss).  The amortized cost basis of debt securities is periodically adjusted for amortization of premiums and accretion of discounts to maturity.  Such amortization is included as a component of interest income or interest expense.  The amortized cost basis of securities sold is based on the specific identification method and all realized gains and losses are recorded as a component within other income (expense).

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The Company reviews the carrying values of its investments and writes down such investments to estimated fair value by a charge to the statements of operations when the severity and duration of a decline in the value of an investment is considered to be other than temporary.  The cost of securities sold or purchased is recorded on the settlement date.

At March 31, 2005, the excess of historical cost over the fair value of the Company’s short-term investments is immaterial.

5.                 Inventories

Inventories include the cost of material, labor and overhead, and are stated at the lower of average cost, determined on the first-in, first-out (FIFO) method, or market.  The Company periodically evaluates its on-hand stock and makes appropriate provisions for any stock deemed as excess or obsolete.

During the first quarter of 2004, the Company recorded a provision of approximately $242,000 for excess inventory.  Such excess inventory was produced in consideration of the Company’s responsibility to be a back-up supplier for the craniomaxillofacial (“CMF”) product line.  The Company sold the assets related to this product line to an affiliate of Medtronic on September 30, 2002.  In April of 2004, Medtronic indicated that it would no longer purchase CMF inventory from the Company under the back-up supply arrangement, leading to the determination that the remaining CMF inventory on hand would not be recoverable.

6.                 Long-Lived Assets

In accordance with SFAS No. 144, “Accounting for Impairment or Disposal of Long-Lived Assets,” the Company assesses certain of its long-lived assets, such as property and equipment and intangible assets other than goodwill, for potential impairment when there is a change in circumstances that indicates carrying values of assets may not be recoverable.  Such long-lived assets are deemed to be impaired when the undiscounted future cash flows expected to be generated by the asset (or asset group) are less than the asset’s carrying amount.  Any required impairment loss would be measured as the amount by which the asset’s carrying value exceeds its fair value, and would be recorded as a reduction in the carrying value of the related asset and a charge to operating expense.  During the first quarter of 2005 and 2004, the Company had no impairment losses.

7.                 Revenue Recognition

Product Sales

The Company sells its products to distributors and, prior to the sale of its Thin Film product line in May 2004, also sold products directly to hospitals.  The Company has agreements with its distributors wherein title and risk of loss pass upon shipment of the products to the distributor.  Revenue is recognized upon shipment of products to distributors following receipt and acceptance of a distributor’s purchase order.  Before the sale of the Thin Film product line in May 2004, revenue from sales to hospitals was recognized upon delivery of the product.

On occasion, the Company offers extended payment terms to customers.  The Company does not recognize revenues under these arrangements until the payment becomes due or is received, if that occurs earlier.  Moreover, the Company warrants that its products are free from manufacturing defects at the time of shipment to its customers.  The Company has recorded a reserve for the estimated costs it may incur under its warranty program.

The majority of the Company’s revenues are from Medtronic, under a Distribution Agreement dated January 5, 2000 and amended December 22, 2000 and October 8, 2002, as well as a Development and Supply Agreement dated January 5, 2000 and amended December 22, 2000 and September 30, 2002.  These revenues are classified as sales to related party in the statements of operations.

Any upfront payments received from license/distribution agreements are recognized as revenues ratably over the period in which the customer benefits from the license/ distribution agreement.  Any recognized amounts are reported as sales to related party or sales to third parties depending upon the counterparty to the transaction.

In September 2002, the Company entered into various agreements with Medtronic and a subsidiary of Medtronic for the sale of the Company’s CMF product line.  The net proceeds received were recorded as deferred gain on sale of assets, related party.  As part of the sale agreement, the Company agreed to act as a back-up supplier to Medtronic until Medtronic could integrate the acquired CMF assets into its manufacturing operations.  The back-up supply agreement required that the Company sell CMF products ordered by Medtronic at the Company’s manufacturing cost.  The Company recognized as revenue in the first quarter of 2004, a portion of the deferred gain upon the sale of CMF products to Medtronic under the Company’s back-up supply arrangement.  The amount of the deferred gain recognized is equal to the excess of the fair value of products sold, based on historical selling prices of similar products, over the Company’s manufacturing cost.  The residual portion of the deferred gain on

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sale of assets was fully recognized in the third quarter of 2004.

Research

The Company earns revenue for performing tasks under research agreements with both commercial enterprises and governmental agencies like the National Institutes of Health (“NIH”).  Milestone payments are considered to be payments received for the accomplishment of a discrete, substantive earnings event.  The non-refundable payment arising from the achievement of a defined milestone is recognized as revenue when the following performance criteria for that milestone have been met:

•                  Substantive effort was required to achieve the milestone,

•                  The amount of the milestone payments appears reasonably commensurate with the effort expended, and

•                  Collection (or retention) of the payment is reasonably assured.

When the Company is reimbursed for costs incurred under grant arrangements with the NIH, the Company recognizes revenues for the lesser of:

•                  Qualifying costs incurred (and not previously recognized), plus any allowable grant fees for which the Company is entitled to funding from the NIH; or,

•                  The outputs generated to date versus the total outputs expected to be achieved under the research arrangement.

Revenue earned under development agreements is classified as research grant or development revenues in the Company’s statements of operations, depending on the nature of the arrangement.  The costs associated with development agreements are recorded as research and development expense.

In the three months ended March 31, 2005 and 2004, the Company recognized NIH grant revenue of $23,000 and $90,000, respectively, and incurred qualifying costs of $22,000 and $99,000.  In the first quarter of 2005, the Company recognized development revenue of $9,000 and incurred costs of $10,000.  There were no comparable development revenues or costs in 2004.

8.                 Warranty

The Company provides a limited warranty under its agreements with its customers for products that fail to comply with product specifications.  The Company has recorded a reserve for estimated costs it may incur under its warranty program.

The following summarizes the Company’s warranty reserve at March 31, 2005 and 2004:

In August 2003, as part of its ongoing product monitoring process, the Company determined that some of the products sold to Medtronic did not meet certain expectations, based on criteria previously communicated by the Company to Medtronic.  The Company agreed to a “no charge” replacement of the affected inventory in the possession of Medtronic.  In the three months ended March 31, 2004, the Company incurred claims of $63,000 related to the replacement of this product.

9.                 Income Taxes

There was no provision or benefit for income taxes recorded due to the Company’s accumulated net loss position and the recognition of a full valuation allowance against deferred tax assets.  There were also no components of current or deferred federal or state income tax provisions recorded for the periods presented.

10.          Earnings (Loss) Per Share

The Company computes income (loss) per share based on the provision of SFAS No. 128, “Earnings Per Share.”  Basic per share data is computed by dividing income (loss) available to common stockholders by the weighted average number of common shares outstanding during the period.  Diluted per share data is computed by dividing net income (loss) available to common stockholders by the weighted average number of common shares outstanding during the period increased to include, if dilutive,

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the number of additional common share equivalents that would have been outstanding if potential common shares had been issued using the treasury stock method.  No common share equivalents were included for the first quarter of 2005, as their effect would be anti-dilutive.

The number of potential common shares excluded from the calculations of diluted income (loss) per share for the first quarter of 2005 and 2004 was 4,892,243 and 2,575,816, respectively.  These potential common shares were related entirely to outstanding but unexercised option awards and warrants.

The composition of the weighted average common shares is as follows:

11.          Long-term Debt

As of March 31, 2005 the future contractual principal payments, for the remainder of 2005 and subsequent years, on all of the Company’s promissory notes are as follows:

12.          Composition of Certain Financial Statement Captions

Inventories

Other Current Assets

Property and Equipment, net

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Intangibles, net

The amortization expense of intangibles for the three months ended March 31, 2005 and 2004 was $67,000 and $68,000, respectively.

Estimated amortization of intangibles for the balance of 2005 and the years ended:

Accounts Payable and Accrued Expenses

13.          Gain on Sale of Assets, Related Party

In January 2004, the Company received a $5,000,000 milestone payment from Medtronic relating to the 2002 disposition of the Company’s CMF product line.  As part of the disposition arrangement, the Company had agreed to complete clinical research regarding Faster Resorbable Polymers, an area that directly relates to the CMF product line transferred to Medtronic.  The Company became entitled to the $5,000,000 payment after fulfilling the research requirements set out in the CMF sale agreement.  The $5,000,000 payment has been recognized as “gain on sale of assets, related party” in the accompanying consolidated condensed statement of operations.

14.          Sale of Thin Film Product Line

In May 2004, the Company sold most, but not all, of its intellectual property rights and tangible assets related to its Thin Film product line to MAST Biosurgery AG, a Swiss corporation (“MAST”) and a subsidiary of MAST.

In addition to transferring certain assets to MAST, the Company agreed to perform the following under the sale agreement:

•                  For a period of up to one year after the closing date, provide up to 300 hours of training to MAST representatives in all aspects of the manufacturing process related to the transferred Thin Film product line,

•                  For a period of up to one year after the closing date, act as a back-up supplier to MAST, and provide, in almost all cases, such product at the Company’s manufacturing cost, and

•                  For a period of up to one year after the closing date, supply or cause its suppliers to provide MAST with specified raw material at the Company’s cost.

Because of these additional performance requirements, the Company did not initially recognize any gain on sale of the Thin Film assets in the accompanying statement of operations.  Instead, the Company initially recorded – and continues to report – the net proceed as deferred gain on sale of assets in the accompanying balance sheets.

The deferred gain on sale of assets will be recognized to gain on sale of assets in the statement of operations when the Company completes all remaining performance obligations under the Thin Film sale agreement.  Specifically, the Company will continue to defer recognition of the gain until the following has been demonstrated:

•                  MAST has stopped relying on the Company to provide product under the back-up supply agreement,

•                  Transfer of Thin Film tangible assets and rights to intangible assets, and

•                  Delivery of all requisite training.

Subject to the resolution of certain allegations set forth by MAST (discussed later in this note), the Company anticipates that it should be able to complete all of its remaining performance obligations, and recognize the deferred gain on sale of assets in the statement of

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operations during 2005.  The relevant allegations pertain to technology transfer.

Under the disposal agreement, the Company is also entitled to the following additional consideration, which has not been recognized in the financial statements covered by this report:

•                  $200,000, payable only upon receipt of 510(k) clearance from the U.S. Food and Drug Administration (“FDA”) for a hernia wrap product (thin film combined product), and

•                  $2,000,000 on or before the earlier of (i) May 31, 2005, known as the “Settlement Date,” or (ii) 15 days after the date upon which MAST has hired a Chief Executive Officer (“CEO”), provided the CEO has held that position for at least four months and meets other requirements specified in the sale agreement.  Note that clause (ii) effectively means that the Company will not receive payment of $2,000,000 before May 31, 2005 unless MAST has hired a CEO on or before January 31, 2005 (four months prior to the Settlement Date).  Moreover, in the event that MAST does not hire a CEO on or before January 31, 2005, MAST may (at its sole option and subject to the requirements of the sale agreement) alternatively provide the Company with a 19% equity interest in the MAST business that is managing the Thin Film assets at May 31, 2005 in lieu of making the $2,000,000 payment.  The Company currently believes that MAST hired a CEO in late 2004 and thus is obligated to pay the $2,000,000 obligation in 2005.  However, MAST has objected to the Company’s interpretation of the agreement and maintains that the individual hired does not qualify as the CEO under its terms, and also has asserted a right to offset based on various alleged wrongs.  The Company intends to vigorously defend against any legal proceedings initiated by MAST and enforce any payments due to the Company.

The Thin Film sale agreement grants MAST a right (the “Purchase Right”) to acquire the Company’s Thin Film-related interests and rights for Japan:

•                  If MAST exercises its option on or before May 31, 2005, the purchase price will be $3,000,000.

•                  After May 31, 2005 and until May 31, 2007, the exercise price of the Purchase Right will equal to the fair market value of the Japanese business, but in no event will be less than $3,000,000.  Moreover, if the Company receives an outside offer for the Japanese business after May 31, 2005 but prior to May 13, 2007, MAST will have a right of first refusal to match the terms of the outside offer.

The Purchase Right is a written option, which must be recognized as a liability, at fair value, in the accompanying financial statements.  The Company has determined that the value of this purchase right is de minimis as of the end of the current reporting period based on a fair value analysis performed by a third party.

15.          Thin Film Japan Distribution Agreement

In the third quarter of 2004, the Company entered into a Distribution Agreement with Senko Medical Trading Co. (“Senko”).  Under this agreement, the Company granted to Senko an exclusive license to sell and distribute certain Thin Film products in Japan.

At the inception of this arrangement, the Company received a $1.5 million license fee was recorded as deferred license fee revenue in the accompanying balance sheet.  No portion of this license fee has been recognized in the statements of operations during any periods covered by these financial statements.  The Company will recognize the deferred license fee as revenue systematically over the term of the Distribution Agreement once “Commercialization” has been achieved. In simplest terms, Commercialization occurs when one or more Thin Film product registrations are completed with the Japanese Ministry of Health, Labour and Welfare (“MHLW”).  The Distribution Agreement contains certain provisions that could require the Company to return a portion of the upfront license fee.  For instance, if it is determined in good faith by the Company and Senko that Commercialization of the Thin Film product is unobtainable, then 50% of the $1,500,000 license fee will be returned to Senko.  Also, if the Company terminates the Distribution Agreement at any time within the initial three years post-Commercialization, for any reason except for material breach by Senko, then a pro-rata share of the license fee will be returned to Senko.  In no event will the Company recognize deferred license fee in the income statement if this would cause the remaining deferred income balance to fall below the amount that the Company potentially would have to refund to Senko.

As discussed in Note 14 above, the Company has granted MAST a Purchase Right to acquire the Company’s Thin Film-related interests and rights in Japan for $3,000,000 or more, depending upon the fair market value upon exercise.

The Company has earned or will be entitled to earn additional payments under the Distribution Agreement based on achieving the following defined milestones:

•                  Upon the Company notifying Senko of completion of the initial regulatory application to the MHLW for the Thin Film product, the Company is entitled to a nonrefundable payment of $1,250,000.  The Company notified Senko of the completion of the regulatory application in September 2004, received payment in October 2004, and recorded deferred development revenue of $1,250,000.  Of the amount deferred, the Company has recognized cumulative development revenues of

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$167,000, representing the fair value of the completed milestones relative to the fair value of the total efforts expected to be necessary to achieve regulatory approval by the MHLW.

•                  Upon the achievement of Commercialization, the Company is entitled to a nonrefundable payment of $250,000.

The Company has agreed to provide back-up supply of products to Senko subject to the terms of the Distribution Agreement in the event that (a) MAST exercises its Purchase Right (see Note 14) and (b) MAST materially fails to deliver product to Senko.  In this circumstance, Senko would pay any amounts due for purchases of product, as well as payments in the nature of royalties, directly to the Company.  The Company would be obliged to remit 5% of the gross margin to MAST on any products sold to Senko.  The Company believes that it is unlikely in practice that this contingency will materialize.  Accordingly, the Company estimates the fair value of this guarantee to be de minimis as of the end of the current reporting period.

16.          Subsequent Event

In April 2005, the Company signed a definitive agreement to sell 1.1 million shares of common stock to an investor at $10.00 per share. The transaction will be completed on or before May 31, 2005.  As part of the agreement, the investor has been granted an option that expires December 31, 2006 to purchase an additional 2.2 million shares of common stock at $10.00 per share.  The investor has also been offered a seat on the Company’s Board of Directors.

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

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

This report contains certain statements that may be deemed “forward-looking statements” within the meaning of United States securities laws.  All statements, other than statements of historical fact, that address activities, events or developments that we intend, expect, project, believe or anticipate will or may occur in the future are forward-looking statements.  Such statements are based upon certain assumptions and assessments made by our management in light of their experience and their perception of historical trends, current conditions, expected future developments and other factors they believe to be appropriate.  The forward-looking statements included in this report are also subject to a number of material risks and uncertainties, including but not limited to the risks described under the “Risk Factors” section in this Management’s Discussion and Analysis of Financial Conditions and Results of Operations.  We encourage you to read those descriptions carefully.  We caution you not to place undue reliance on the forward-looking statements contained in this report.  These statements, like all statements in this report, speak only as of the date of this report (unless an earlier date is indicated) and we undertake no obligation to update or revise the statements except as required by law.  Such forward-looking statements are not guarantees of future performance and actual results will likely differ, perhaps materially, from those suggested by such forward-looking statements.

Overview

Our primary focus is to discover and develop therapies for cardiovascular disease, spine and orthopedic conditions, gastrointestinal disorders and new approaches for aesthetic and reconstructive surgery using regenerative cells from adipose tissue (human fat tissue).  Adipose tissue is the richest and most accessible source for regenerative cells in the human body.  This tissue contains adult stem cells, angiogenic cells (blood vessel forming) and other regeneration-promoting cells.

Our lead stem and regenerative cell therapy, currently in preclinical testing, targets cardiovascular disease, including myocardial infarction.  Additionally, we have a pipeline of other preclinical investigational therapies that target multiple therapeutic areas.  To facilitate the processing and delivery of adipose-derived regenerative cells, we are designing a proprietary point-of-care system, Celution™, to isolate and concentrate a patient’s own regenerative cells in approximately one hour.  Our goal is to commercialize systems that may be used across multiple therapeutic applications.  Specifically, the commercialization model will comprise the sale of devices and related consumables.

Additionally, we have two bioresorbable surgical implant product lines. We manufacture the HYDROSORB™ family of FDA-cleared bioresorbable spine and orthopedic implants, which are distributed worldwide exclusively through Medtronic, Inc. (“Medtronic”).  Moreover, although we disposed of most of our Thin Film product line in 2004, we retained the rights to manufacture and market such products in Japan.  Accordingly, we are developing the Thin Film bioresorbable implants for Senko Medical Trading Co. (“Senko”), which has exclusive distribution rights to these products in Japan.

For the next several years we plan to fund the research and development of our regenerative cell technology through:

•                  Existing cash reserves;

•                  Potential future financings;

•                  Potential future grants;

•                  Profits, if any, from bioresorbable product sales;

•                  Cash flows related to recent product line divestitures and licensing agreements; and

•                  Potential regenerative cell technology partnerships.

During this time, we expect to:

•                  Complete the engineering and design of our point-of-care regenerative cell technology system and seek relevant regulatory clearances;

•                  Continue preclinical development of regenerative cell therapies for multiple therapeutic applications;

•                  Expand our intellectual property position related to our regenerative cell program;

•                  Advance regenerative cell technology programs into clinical development;

•                  Form at least one key regenerative cell related collaboration outside the area of cardiovascular disease; and

•                  Pursue available grant opportunities.

Our total revenues for the first quarter of 2005 were $1,789,000 compared to $2,352,000 for the same period in 2004. The decline in revenues is attributable to the absence of Craniomaxillofacial (“CMF”) and Thin Film sales as a result of divesting these product lines to Medtronic and MAST Biosurgery AG (“MAST”), respectively. Of the total revenue for the first quarter of 2005, $1,755,000 was attributable to HYDROSORB™ sales, compared to $1,647,000 for the same period in 2004. HYDROSORB™ sales increased for the second consecutive quarter due predominantly to stocking orders for the radiographically identifiable Spine System products. The

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inventory build-up of HYDROSORB™ products during the first quarter of 2005 may not be indicative of any future ordering patterns or trends by Medtronic, as their marketing efforts have historically been below our expectations, which have resulted in slower than anticipated end-use market penetration.

Net loss for the quarter ended March 31, 2005 was $4,527,000 compared to net income of $1,490,000 for the same period in 2004, which included a one time, $5,000,000 gain related to the sale of the CMF product line to Medtronic. Net loss in the first quarter of 2004 before the one time gain was $3,510,000 as shown in the table below (1).

(1) We believe adjusted net loss is a useful measure by which investors can evaluate our operating performance on a comparable basis, unaffected by the large one-time payment we received in the first quarter of 2004.

The increase in adjusted net loss during the first quarter of 2005 compared to the first quarter of 2004 is due in part to expenses related to research and development efforts for stem and regenerative cell therapies.

We ended the first quarter of 2005 with $8,165,000 in cash, cash equivalents and short-term investments.  We expect to increase our cash position by $11,000,000 on or before May 31, 2005 through an equity placement agreement we entered into after the end of the quarter.

Equity Placement

After the end of the quarter, we signed a definitive agreement to raise $11.0 million by selling 1.1 million shares of common stock to an investor at $10.00 per share. The transaction will be completed on or before May 31, 2005.  As part of the agreement, the investor has been granted an option that expires December 31, 2006 to purchase an additional 2.2 million shares of common stock at $10.00 per share.  The investor has also been offered a seat on our Board of Directors.

2005 Financial Projections

For the next several years, we expect to incur increasing losses as we invest into the research and development of our regenerative cell technology.  Such losses will continue until the first regenerative cell technology products become commercialized.

In 2005, we expect bioresorbable technology-related revenues of $6,000,000 to $9,000,000. We are preparing for the commercialization of Thin Film products in Japan, which we anticipate to occur in 2005 or early 2006.  Commercialization of the Thin Film product line may result in revenues related to stocking orders and royalty payments from Senko, provided MAST does not exercise its option for Thin Film-related interests and rights in Japan (see Disposition of Product Lines- Sale of Thin Film Product Line below for further details regarding this option).  If MAST does exercise its option, they are required to make at least a $3,000,000 payment to us and equally share with us their gross profits and royalties from Senko for a three-year period post-commercialization.

Further, we expect our overall research and development expenses in 2005 to be in the range of $11,000,000 to $13,000,000, as we continue preclinical studies and prepare to enter clinical studies in 2006 related to our regenerative cell technology.  We expect our sales and marketing expenses to decline significantly this year as we will no longer incur expenses related to Thin Film independent sales representatives.

Disposition of Product Lines

Sale of Craniomaxillofacial Product Line

In September 2002, we entered into an Asset Purchase Agreement (the “Agreement”) to sell assets related to our CMF implant and accessory product line to Medtronic for what resulted in total net consideration of $15,500,000.  In accordance with the terms of the Agreement, we received an initial payment of $13,000,000 from Medtronic and a first milestone payment of $1,000,000 in the fourth quarter of 2002.  A final milestone payment of $1,500,000 was received in 2004.

The Agreement requires us not to market in the craniomaxillofacial field, for five years, any products that compete with the acquired product line.  Additionally, during the technology transfer transition period, we agreed to be a back-up supplier of CMF products to Medtronic at a price equal to our cost of manufacture.

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The Agreement also allowed us to receive up to $5,000,000 if and when we completed successful clinical evaluations for a new faster-resorbing polymer product, as defined in the Agreement.  In January 2004, after we completed the successful clinical evaluations, we received a $5,000,000 milestone payment from Medtronic and it was recognized as gain on sale of assets, related party, in the accompanying statements of operations.

In a separate, but simultaneous, 2002 transaction, we paid Medtronic $4,000,000 in cash to amend an existing Development and Supply Agreement (the “Amended Development Agreement”, and collectively with the Asset Purchase Agreement, the “Agreements”) to remove a preexisting contractual right of first offer for distributorship by Medtronic of our bioresorbable thin film products for use in various types of soft tissue surgical applications.  Medtronic will retain its right of first offer for distributorship of our other bioresorbable products in all fields, as well as to our bioresorbable thin film products for use in the spinal application field.  In addition, the term of the Amended Development Agreement with Medtronic was extended to September 30, 2012.

We accounted for the net proceeds of the Agreements as deferred gain on sale of assets, related party.  This gain was to be recognized only as certain events occurred.  For instance, we recognized a portion of the deferred gain upon the sale of the CMF products to Medtronic under our back-up supply arrangement, which provided for sales of the CMF products to Medtronic at cost.  The amount of the deferred gain recognized is equal to the excess of the fair value of products sold, based on historical selling prices of similar products, over the Company’s manufacturing cost.  The remainder of the deferred gain was recognized in the third quarter of 2004 when the technology and know-how transfer was completed pursuant to the contract terms.

Sale of Thin Film Product Line

In May 2004, we sold most, but not all, of our intellectual property rights and tangible assets related to our Thin Film product line to MAST and one of its subsidiaries.  We have received $7,000,000 in cash and might receive the following additional contingent consideration:

•                    $200,000, payable only upon receipt of 510(k) clearance from the U.S. Food and Drug Administration for a hernia wrap product (thin film combination), and

•                    $2,000,000 on or before the earlier of (i) May 31, 2005 or (ii) 15 days after the date upon which MAST has hired a Chief Executive Officer, provided the Chief Executive Officer has held that position for at least four months and meets other requirements specified in the sale agreement.  If MAST had not hired a Chief Executive Officer by January 31, 2005, MAST may, at its sole option, provide us on May 31, 2005 with a 19% equity interest in the MAST business that is managing the Thin Film assets at May 31, 2005 instead of making the $2,000,000 cash payment.  We believe that MAST hired a CEO in late 2004 and, thus, became obliged to pay the $2,000,000 obligation in early 2005.  However, MAST has objected to our interpretation of the agreement and maintains that the individual hired does not qualify as the CEO under its terms.  Regardless, MAST’s obligation is due to us no later than May 31, 2005, although MAST has now also asserted a right to offset based on various alleged wrongs.  We intend to vigorously defend against any legal proceedings initiated by MAST and enforce any payments due to MacroPore.

As part of the Thin Film disposition agreement, and for a period of up to one year, we must provide training to MAST representatives in all aspects of the manufacturing process related to the transferred Thin Film product line, and act in the capacity of a back-up supplier to MAST.  Under the back-up supply agreement, we have agreed in nearly all cases to supply product ordered by MAST at our manufacturing cost.

Because of these and other additional performance requirements, we did not initially recognize any gain on sale of the Thin Film assets in our statement of operations.  Instead, we initially recorded approximately $6,450,000 as deferred gain on sale in the balance sheet.  The amount recorded as deferred gain on sale does not include the potential contingent consideration described above, which will only be added to the deferred gain on sale when the contingencies are resolved.

We do not expect to complete our performance obligations until later in 2005 and, accordingly, will not recognize the majority of the deferred gain until that time.  The recognition of the gain will also be dependent upon the resolution of certain MAST allegations regarding technology transfer.

In 2004 we recognized $772,000 of the deferred gain as revenues related to the sale of Thin Film products to MAST under the back-up supply agreement at cost.  No deferred gain was recognized as revenue in the first quarter of 2005 because there were no shipments of product to MAST.  The recognition of the deferred gain was necessary in 2004 in order to state revenues at fair value of products sold, based on historical selling prices of similar products, over the Company’s manufacturing cost.

Even after consummation of the Thin Film asset disposition, we retained all rights to Thin Film business in Japan (subject to a purchase option of MAST, as described in the next paragraph below), and we received back a license of all rights to Thin Film technologies in the:

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•                    Spinal field, exclusive at least until 2012, and

•                    Field of regenerative medicine, non-exclusive on a perpetual basis.

The sale agreement grants MAST a “Purchase Right” to acquire our Thin Film-related interests and rights for Japan at the following terms:

•                  If MAST exercises its option on or before May 31, 2005, the purchase price will be $3,000,000.

•                  After May 31, 2005 but before May 31, 2007, the exercise price of the Purchase Right will be equal to the fair market value of the Japanese business, but in no event will be less than $3,000,000.  Moreover, between June 1, 2005 and May 31, 2007 MAST will have a right of first refusal to match the terms of any outside offer to buy our Japanese Thin Film business.

If MAST exercises the Purchase Right, MAST will become obligated to reimburse us for certain costs we have incurred or will incur related to product development and protection of intellectual property rights in the country of Japan.  Moreover, under certain circumstances MAST must share certain milestone payments and gross profits with us, if MAST exercises the Purchase Right and Thin Film products are marketed in Japan.

Thin Film Japan Distribution Agreement

In the third quarter of 2004, we entered into a Distribution Agreement with Senko.  Under this agreement, we granted to Senko an exclusive license to sell and distribute certain Thin Film products in Japan.  Specifically, the license covers Thin Film products with the following indications:

•                  Anti-adhesion,

•                  Soft tissue support, and

•                  Minimization of the attachment of soft tissues throughout the body.

The Distribution Agreement with Senko commences upon “commercialization.”  In simplest terms, commercialization occurs when one or more Thin Film product registrations are completed with the MHLW.

Following commercialization, the Distribution Agreement has a duration of five years and is renewable for an additional five years after reaching mutually agreed minimum purchase guarantees.

We received a $1,500,000 upfront license fee from Senko.  We have recorded the $1,500,000 received as deferred license fee revenue in the accompanying balance sheet.  Half of the license fee is refundable if the parties agree commercialization is not achievable and a proportional amount is refundable if we terminate the arrangement, other than for material breach by Senko, before three years post-commercialization.

Accordingly, we will begin to recognize this $1,500,000 license fee as revenues only after commercialization has been achieved.  Moreover, we will not recognize all of the revenues at one time – instead, we will reflect the fee in revenues on a systematic basis over the expected period of time we anticipate that Senko will benefit from the arrangement.  However, we will not recognize deferred license fee revenue in the statements of operations if this would cause the remaining deferred license fee revenue balance to fall below the amount that we potentially would have to refund to Senko.

We will also be entitled to earn additional payments from Senko based on achieving defined milestones.  We will recognize such payments as revenues when the performance criteria for a milestone have been met, presuming that achievement of the milestone involves substantive effort and the fees received are commensurate with the level of effort expended.  On September 28, 2004, we notified Senko of completion of the initial regulatory application to the MHLW for the Thin Film product.  As a result, we became entitled to a nonrefundable payment of $1,250,000, which we received in October 2004 and recorded as deferred development revenue.  Of the amount deferred, we recognized $167,000 (totaling $9,000 and $158,000 in 2005 and 2004, respectively) as development revenues.  The amount recognized as development revenues represents the relative fair value of the completed milestone as compared with the fair value of all milestones expected to be necessary to achieve regulatory approval by the MHLW.

Results of Operations

Revenues

The following table summarizes the components of our revenues for the three months ended March 31, 2005 and 2004:

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•                 Spine and orthopedic revenues represent sales of bioresorbable implants used in spine and orthopedic surgical procedures.  These revenues were dominated by stocking orders during the first quarter of 2005 for the pre-launch of our radiographically identifiable Spine System products, which received FDA clearance in August of 2004.  This product represents the latest design enhancement to our family of HYDROSORB™ products.  Its unique feature is the integration of small markers of radiographically visible resorbable material within the product.  These patent pending markers enable the surgeon to preserve the benefit of fusion visualization, while simultaneously tracking the exact position of the implant during the intraoperative and postoperative periods.  Because the markers are fabricated from a resorbable material, they do not pose the issues that permanent markers could pose after the implant resorbs.

Surgeon demand for bioresorbable devices as well as the pre-launch of a new product within the HYDROSORB™ products portfolio contributed to spine and orthopedic revenues during the three months ended March 31, 2004.

Refer to “The future” discussion below for our expectations regarding the outlook for spine and orthopedic revenues.  Note that Medtronic owns approximately 7.2% of our outstanding common stock at March 31, 2005.

•                     Thin Film product revenues in 2004 represent sales of SurgiWrap™ bioresorbable Thin Film used to support and reinforce soft tissues and to minimize tissue attachment to the device in case of contact with the viscera (organs of the body).  We sold most, but not all, of our intellectual property rights and tangible assets related to our Thin Film product line to MAST in the second quarter of 2004.  We are obliged by contract to sell these products to MAST at our manufacturing costs.  However, as MAST begins to assume the manufacturing process, we expect domestic revenue from Thin Film products to decline and end in 2005.  No revenues from the Thin Film product line were recognized during the first quarter of 2005.

•                  The CMF product revenues represent sales of the CMF product line used for trauma and reconstructive procedures in the midface and craniofacial skeleton (the head and skull).  We sold this product line to Medtronic in 2002.  As with the Thin Film products, we sold CMF products at cost in 2004 under a contractual back-up supply agreement with Medtronic.  A portion of the deferred gain related to sale of assets was recognized in order to reflect the fair value of products sold, based on historical selling prices of similar products, over our manufacturing cost.  During the third quarter of 2004, we completed all remaining performance obligations related to the 2002 sale of the CMF product line to Medtronic.  Therefore, we did not earn any CMF product revenues during the first quarter of 2005 and do not expect to recognize revenue on this product line in the future.

•                     The research grant revenue relates to our agreement with the National Institutes of Health (“NIH”).  Under this arrangement, the NIH reimburses us for “qualifying expenditures” related to research on Adipose-Derived Cell Therapy for Myocardial Infarction.  To receive funds under the grant arrangement, we are required to (i) demonstrate that we incurred “qualifying expenses,” as defined in the grant agreement between the NIH and us, (ii) maintain a system of controls, whereby we can accurately track and report all expenditures related solely to research on Adipose-Derived Cell Therapy for Myocardial Infarction, and (iii) file appropriate forms and follow appropriate protocols established by the NIH.

During the three months ended March 31, 2005 and 2004, we incurred $22,000 and $99,000, respectively, in qualifying expenditures.  We also earned $1,000 in allowable grant fees in 2005, for a total of $23,000 in reimbursements.  We have recorded revenues for the same amount.  Although we had incurred $99,000 in costs during the three months ended March 31, 2004, we recorded revenues of $90,000, consistent with our policy to recognize revenues under the NIH grant arrangement as the lesser of (i) qualifying costs incurred (and not previously recognized), plus our allowable grant fees for which we are entitled to funding or (ii) the amount determined by comparing the outputs generated to date versus the total outputs expected to be achieved under the research arrangement.

•                  Under a Distribution Agreement with Senko we are entitled to earn payments based on achieving the following defined milestones:

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•                  Upon notifying Senko of completion of the initial regulatory application to the MHLW for the Thin Film product, we were entitled to a nonrefundable payment of $1,250,000.  We so notified Senko on September 28, 2004, received payment in October of 2004, and recorded deferred development revenue.  Of the amount deferred, we have recognized development revenues of $9,000 during the three months ended March 31, 2005, representing the relative fair value of the completed milestones completed this quarter as compared with the fair value of all milestones expected to be necessary to achieve regulatory approval by the MHLW;

•                  Upon the achievement of commercialization of the Thin Film product line in Japan, we are entitled to a nonrefundable payment of $250,000.  As of March 31, 2005, commercialization had not occurred; however, commercialization is expected later in 2005 or early 2006.

The future:  We sell our spine and orthopedic products exclusively to Medtronic at fixed selling prices that are subject to adjustment biannually (based on Medtronic’s selling prices to its customers).  Our revenue from this product line is dependent upon the market’s adoption of our technology, which is largely dependent upon Medtronic’s marketing efforts and pricing strategies.  To increase our revenues from spine and orthopedic products, we depend largely on Medtronic’s ability and commitment to build and expand HYDROSORB™ market share.  We currently expect market demand and revenues for our HYDROSORB™ products to increase during the remainder of 2005, particularly as Medtronic and its customers employ our radiographically identifiable Spine System products.  We have, however, been disappointed in the past by Medtronic’s level of effort in marketing our HYDROSORB™ products, and if their level of effort does not improve our sales will suffer.

We are entitled to receive up to $850,000 in additional grants related to Adipose-Derived Cell Therapy for Myocardial Infarction as defined by the NIH grant agreement for Phase II research.  To date, we have received and recognized $251,000 of such funding.  We expect to incur “qualifying expenses” in 2005 and 2006 of $599,000.  Subject to availability of NIH funds and satisfactory progress toward meeting the goals and objectives of our grant application, we expect to recognize any remaining grant revenues during 2005 and 2006.

We will continue to recognize revenue from the milestone payment from Senko, based on the fair value of the milestones completed relative to the total efforts expected to be necessary to obtain regulatory clearance with the MHLW.  Obtaining regulatory clearance with the MHLW for initial commercialization is expected in 2005 or early 2006.  Accordingly, we expect to recognize approximately $1,333,000 in revenues associated with this milestone arrangement throughout 2005 and the early part of 2006.

To the extent that sales of our spine and orthopedic products to Medtronic (and to Medtronic’s customers) increase, we expect the percentage of revenues attributable to Medtronic to increase as sales of Thin Film become a lower percentage of our overall sales revenue, although this may change when commercialization of the Thin Film products in Japan occurs and we begin Thin Film shipments to Senko.

Cost of revenues

Cost of revenues includes material, manufacturing labor, overhead costs and an inventory provision.  The following table summarizes the components of our cost of revenues for the three months ended March 31, 2005 and 2004:

•                  The cost of revenues, as a percent of revenues (excluding inventory provision amounts), increased 11.5% in the three months ended March 31, 2005 as compared to the same period in 2004.  The percentage increase in 2005 from 2004 was due to the decrease in sales volume and the insufficient production of inventory to absorb fixed manufacturing and labor expense.  Excess manufacturing capacity expensed in the three months ended March 31, 2005 was $102,000 as compared to $106,000 in the same period in 2004.

•                  The $242,000 inventory provision during the three months ended March 31, 2004 with no comparable charges in 2005 related to excess inventory.  Such inventory was produced in consideration of our responsibility to be a back-up supplier for the CMF product line.  We sold the assets related to this product line to a subsidiary of Medtronic in September 2002.  In April of 2004, Medtronic indicated that it would no longer purchase CMF inventory from us under the back-up supply

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arrangement, leading to our determination that the remaining CMF inventory on hand would not be recoverable.

The future:  Ceasing to manufacture the CMF product line as well as the May 2004 sale of our non-Japan bioresorbable Thin Film product line will deprive us of economies of scale and will negatively impact our margins unless other sources of revenue grow large enough to compensate for the lost revenue.

Research and development expenses

Research and development expenses include costs associated with the design, development, testing and enhancement of our products, regulatory fees, the purchase of laboratory supplies and preclinical studies.  The following table summarizes the components of our research and development expenses for the three months ended March 31, 2005 and 2004:

•                    Regenerative cell technology expenses relate to the development of a technology platform that involves using adipose (fat) tissue as a source for autologous regenerative cells for therapeutic applications.  The increases in regenerative cell technology expenses from 2004 to 2005 resulted primarily from the hiring of additional researchers, engineers and support staff.  We incurred an additional $277,000 in labor-related expenses in the three months ended March 31, 2005, as compared with 2004.  The remainder of the increases as compared with 2004 related to increases in legal, research supplies, consulting fees and facility expenses of $799,000 in the three months ended March 31, 2005.

•                    Bioresorbable polymer surgical implants platform technology is used for development of spine and orthopedic products.  The decrease in research and development costs associated with bioresorbable polymer implants in 2005 as compared with 2004 was a result of a strategic decision to strongly focus our research and development efforts on our regenerative cell technology.

•                  In 2004, we entered into an agreement with the NIH to reimburse us for up to $950,000 (Phase I $100,000 and Phase II $850,000) in “qualifying expenditures” related to research on Adipose-Derived Cell Therapy for Myocardial Infarction.  In the three months ended March 31, 2005, we incurred $22,000 of direct qualifying expenses relating to Phase II.  In the three months ended March 31, 2004, we incurred $99,000 of direct qualifying expenses relating to Phase I of the agreement.

•              Under a Distribution Agreement with Senko we are responsible for the completion of the initial regulatory application to the MHLW and commercialization of the Thin Film product line in Japan.  Commercialization occurs when one or more Thin Film product registrations are completed with the MHLW.  During the three months ended March 31, 2005, we incurred $37,000 of expenses related to this regulatory and registration process.

The future:  We are developing a system to isolate autologous, homologous-use, regenerative cells.  Simultaneously, we are generating scientific knowledge through internal research to support the clinical use of these cells and have made significant progress in understanding the potential clinical applications.  Our most advanced stem and regenerative cell therapy currently in preclinical testing is for the repair of cardiovascular muscle tissue that is damaged after a heart attack.  Our strategy is to continue to increase our research and development efforts in this field and we anticipate expenditures in this area of research to be approximately $8,000,000 to $10,000,000 in 2005.  We are also researching therapies for spine and orthopedic conditions, gastrointestinal disorders and new approaches for aesthetic and reconstructive surgery.  The expenditures will primarily relate to developing therapeutic applications and conducting preclinical studies on harvesting therapeutically useful quantities of regenerative cells for cardiac tissue repair, bone regeneration, cosmetic and reconstructive surgery.

We expect that our current research and development expenditures in the bioresorbable platform technology will decrease as compared with past levels because of the sale of our CMF and Thin Film (non-Japan territory) product lines.  However, we will continue to invest in product development for biomaterial/polymer products to develop our pipeline of new and next generation spine and orthopedic products.

We were successful with Phase I of the NIH research on Adipose-Derived Cell Therapy for Myocardial Infarction.  Therefore, we were awarded Phase II of the NIH research grant.  We expect additional research expenses to be incurred related to Phase II of this

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project during the remainder of 2005 and 2006.

Sales and marketing expenses

Sales and marketing expenses include costs of marketing personnel, tradeshows, and promotional activities and materials.  It excludes related stock based compensation expenses.  Medtronic is responsible for the distribution, marketing and sales support of our spine and orthopedic devices.  Our bioresorbable Thin Film product line (before the sale of the non-Japan Thin Film business to MAST in May 2004) was distributed domestically through a dedicated sales force, independent sales representatives and internationally through independent distributors.  The following table summarizes the components of our sales and marketing expenses for the three months ended March 31, 2005 and 2004:

Note: Certain prior period amounts have been reclassified to conform to current period presentation.

•                  General corporate marketing expenditures relate to expenditures for maintaining our corporate image and reputation within the research and surgical communities.  The decrease in 2005 as compared to 2004 was due to one-time costs incurred for an educational program we created in 2004 to inform end-users and distributors of the benefits and surgical applications for our biomaterials products.  Additionally, in 2005 we allocated fewer personnel resources to general corporate marketing.

•                  Domestic sales and marketing relate to expenses associated with managing our domestic bioresorbable Thin Film product distribution, which included independent sales representatives and our domestic Thin Film sales consultants and marketing staff.  The elimination of such expenses in 2005 as compared to 2004 was due to the transfer of our sales force and marketing staff to MAST upon the sale of the Thin Film product line to MAST in May 2004.

•                  International sales and marketing relate to costs associated with developing an international bioresorbable Thin Film distributor, supporting a bioresorbable Thin Film sales office in Japan and establishing relationships to support and promote our regenerative cell technology.  The increased spending in 2005 as compared to 2004 relates to an increase in personnel resources currently dedicated to this marketing group.

The future:  We project that corporate marketing as well as our international sales and marketing expenditures will remain reasonably stable for the balance of 2005.

General and administrative expenses

General and administrative expenses include costs for administrative personnel, legal and other professional expenses and general corporate expenses.  It excludes related stock based compensation expenses.  The following table summarizes the general and administrative expenses for the three months ended March 31, 2005 and 2004: