UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

ý		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.

		For the quarterly period ended June 30, 2004.

OR

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.

		For the transition period from to

Commission File Number: 1-11388

PLC SYSTEMS INC.
(Exact Name of Registrant as Specified in Its Charter)

Yukon Territory, Canada		04-3153858
(State or Other Jurisdiction of Incorporation or Organization)		(I.R.S. Employer Identification No.)

10 Forge Park, Franklin, Massachusetts		02038
(Address of Principal Executive Offices)		(Zip Code)

Registrant’s telephone number, including area code: (508) 541-8800

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

Class		Outstanding at August 9, 2004
Common Stock, no par value		30,058,877

PLC SYSTEMS INC.

Index

Part I.	Financial Information:

	Item 1.	Financial Statements

		Condensed Consolidated Balance Sheets (unaudited)

		Condensed Consolidated Statements of Operations (unaudited)

		Condensed Consolidated Statements of Cash Flows (unaudited)

		Notes to Condensed Consolidated Financial Statements (unaudited)

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

	Item 3.	Quantitative and Qualitative Disclosures about Market Risk

	Item 4.	Controls and Procedures

Part II.	Other Information:

	Item 4.	Submission of Matters to a Vote of Security Holders

	Item 6.	Exhibits and Reports on Form 8-K

PLC SYSTEMS INC.

Part I. Financial Information

Item 1. Financial Statements

PLC SYSTEMS INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands)

(Unaudited)

	June 30, 2004			December 31, 2003
ASSETS
Current assets:
Cash and cash equivalents	$	10,251		$	6,377
Accounts receivable, net of allowance of $127 and $115 in 2004 and 2003, respectively	1,182			1,239
Lease receivables	156			376
Inventories, net	1,148			885
Prepaid expenses and other current assets	662			490
Total current assets	13,399			9,367

Equipment, furniture and leasehold improvements, net	257			206
Other assets	258			276
Total assets	$	13,914		$	9,849
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	551		$	297
Accrued compensation	432			376
Accrued other	316			358
Deferred revenue	974			555
Secured borrowings	156			376
Total current liabilities	2,429			1,962

Deferred revenue	4,447			331
Total long-term liabilities	4,447			331
Commitments and contingencies

Stockholders’ equity:
Preferred stock, no par value, unlimited shares authorized, none issued and outstanding
Common stock, no par value, unlimited shares authorized, 30,059 and 29,896 shares issued and outstanding at June 30, 2004 and December 31, 2003, respectively	93,725			93,636
Accumulated deficit	(86,350		)	(85,749		)
Accumulated other comprehensive loss	(337		)	(331		)
Total stockholders’ equity	7,038			7,556
Total liabilities and stockholders’ equity	$	13,914		$	9,849

The accompanying notes are an integral part of the condensed consolidated financial statements.

PLC SYSTEMS INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(Unaudited)

	Three Months Ended June 30,					Six Months Ended June 30,
	2004			2003		2004			2003
Revenues:
Product sales	$	1,354		$	1,578	$	2,885		$	2,984
Placement and service fees	442			433		820			761
Total revenues	1,796			2,011		3,705			3,745

Cost of revenues:
Product sales	575			499		1,165			1,024
Placement and service fees	172			125		348			241
Total cost of revenues	747			624		1,513			1,265

Gross profit	1,049			1,387		2,192			2,480

Operating expenses:
Selling, general and administrative	866			975		1,856			1,831
Research and development	516			220		1,045			461
Total operating expenses	1,382			1,195		2,901			2,292

Income (loss) from operations	(333		)	192		(709		)	188

Other income, net	82			11		108			30

Net income (loss)	$	(251	)	$	203	$	(601	)	$	218

Basic and diluted earnings (loss) per share	$	(0.01	)	$	0.01	$	(0.02	)	$	0.01

Average shares outstanding:
Basic	30,056			29,810		29,990			29,804
Diluted	30,056			30,019		29,990			29,916

The accompanying notes are an integral part of the condensed consolidated financial statements.

PLC SYSTEMS INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

	Six Months Ended June 30,
	2004			2003
Operating activities:
Net income (loss)	$	(601	)	$	218

Adjustments to reconcile net income to net cash provided by (used for) operating activities:
Depreciation and amortization	71			74
Change in assets and liabilities:
Accounts receivable	59			(139		)
Inventory	(262		)	(183		)
Prepaid expenses and other assets	(173		)	(443		)
Accounts payable	254			129
Deferred revenue	4,535			670
Accrued liabilities	15			(351		)
Net cash provided by (used for) operating activities	3,898			(25		)

Investing activities:
Investment in equipment	(104		)	—

Financing activities:
Proceeds from sales of common shares	90			19
Secured borrowings	—			(58		)
Net cash provided by (used for) financing activities	90			(39		)

Effect of exchange rate changes on cash and cash equivalents	(10		)	25
Net increase (decrease) in cash and cash equivalents	3,874			(39		)

Cash and cash equivalents at beginning of period	6,377			5,932
Cash and cash equivalents at end of period	$	10,251		$	5,893

The accompanying notes are an integral part of the condensed consolidated financial statements.

PLC SYSTEMS INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2004

1. Nature of Business

PLC Systems Inc. (“PLC” or the “Company”) is a medical device company that specializes in the design, development and manufacturing of a patented carbon dioxide (CO₂) laser and disposable handpieces, known as The Heart Laser System, that is used to treat patients with severe angina in a surgical procedure known as transmyocardial revascularization, or TMR. In the United States, the Company sells its TMR products to Edwards Lifesciences. Edwards has the exclusive right to market and distribute the Company’s TMR products in the United States.

PLC’s current business strategy involves broadening and diversifying its product portfolio beyond its current TMR offerings, by developing or acquiring new and innovative medical devices to address cardiac and vascular related markets. In February 2004, the Company, consistent with this business strategy, entered into a new agreement with Edwards to develop and manufacture a surgical cardiac ablation laser designed to treat cardiac arrhythmias (See Note 3).

Edwards is our largest shareholder, owning approximately 18% of our outstanding common stock as of June 30, 2004, and has a representative on our Board of Directors. Edwards is also our largest customer, accounting for approximately 89% of the Company’s total sales in 2003 and 87% of the Company’s total sales for the six months ended June 30, 2004.

2. Basis of Presentation

The accompanying unaudited condensed consolidated financial statements of the Company have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three and six months ended June 30, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004. These financial statements should be read in conjunction with the consolidated financial statements and footnotes thereto included in the Company’s annual report on Form 10-K for the year ended December 31, 2003.

3. Edwards Transaction

In February 2004, the Company signed an agreement with Edwards to assume development of a surgical cardiac ablation laser system designed to treat cardiac arrhythmias. Under the terms of the agreement, the Company will have exclusive manufacturing rights to build the new laser system and other related surgical products. The Company will be responsible, among other things, for ongoing research and development and manufacture of the product and for obtaining regulatory approvals. Edwards will be responsible for the approval, funding and conduct of any clinical studies designed to obtain data in support of a new product approval

or clearance as required by the FDA or other regulatory body.

In conjunction with signing this new agreement, the terms of the Company’s TMR distribution agreement with Edwards were modified to (1) extend the term of the agreement until at least October 17, 2017 and (2) reduce the Company’s share of revenue on TMR kits sold to hospitals. The Company received as consideration from Edwards, a lump-sum payment of $4,533,333, which initially was recorded as deferred revenue in the Company’s consolidated balance sheet. The Company expects to amortize the $4,533,333 into its consolidated statement of operations as revenue over the next seven years under the units-of-revenue method as prescribed by Emerging Issues Task Force (EITF) 88-18, Sales of Future Revenue. For the three and six months ended June 30, 2004, the Company has recorded amortization of $57,000 and $72,000, respectively.

4. Earnings (Loss) per Share

In 2004, basic and diluted loss per share was computed using only the weighted average number of common shares outstanding during the period without giving effect to any potential future issues of common stock related to stock option programs and warrants since their inclusion would be antidilutive.

In 2003, basic earnings per share was computed using only the weighted average number of common shares outstanding during the period, while diluted earnings per share was computed using the weighted average number of common shares outstanding during the period plus the effect of outstanding stock options and warrants using the treasury stock method. In calculating diluted earnings per share, the dilutive effect of stock options and warrants is computed using the average market price for the respective period.

For the three and six months ended June 30, 2004 and 2003, 6,190,422 and 4,668,430 shares attributable to outstanding stock options and warrants were excluded from the calculation of diluted earnings (loss) per share because the effect was antidilutive. The following table sets forth the computation of basic and diluted earnings (loss) per share:

	Three Months Ended June 30,					Six Months Ended June 30,
	2004			2003		2004			2003
	(In thousands, except earnings per share)
Net income (loss) available for common shareholders	$	(251)		$	203	$	(601)		$	218
Weighted average outstanding shares of common stock	30,056			29,810		29,990			29,804
Dilutive effect of employee stock options	—			209		—			112
Common stock and common stock equivalents	30,056			30,019		29,990			29,916

Earnings (loss) per share:
Basic	$	(0.01	)	$	0.01	$	(0.02	)	$	0.01
Diluted	$	(0.01	)	$	0.01	$	(0.02	)	$	0.01

5. Stock Based Compensation

The Company grants stock options for a fixed number of shares to employees and certain other individuals with exercise prices equal to the fair value of the shares at the dates of grant. The Company has adopted the disclosure only provisions of Statement of Financial Accounting Standards No. 123, Accounting for Stock-based Compensation (“FAS 123”) as amended, and will continue to account for its stock option plans in accordance with the provisions of Accounting Principles Board Opinion 25, Accounting for Stock Issued to Employees.

The following table illustrates the effect on net income (loss) and basic earnings (loss) per share if the Company had applied the fair value recognition provisions of FAS 123 to stock-based employee compensation:

	Three Months Ended June 30,						Six Months Ended June 30,
	2004			2003			2004			2003
	(In thousands, except per share data)
Net income (loss) attributable to common stockholders— As reported	$	(251	)	$	203		$	(601	)	$	218
Deduct total stock-based compensation expense determined under fair value based method for all stock option awards	(359		)	(35		)	(392		)	(76		)
Net income (loss) attributable to common stockholders-Pro forma	$	(610	)	$	168		$	(993	)	$	142
Earnings (loss) per basic and diluted share attributable to common stockholders-As reported	$	(0.01	)	$	0.01		$	(0.02	)	$	0.01
Earnings (loss) per basic and diluted share attributable to common stockholders-Pro forma	$	(0.02	)	$	0.01		$	(0.03	)	$	0.00

The fair value of issued options at the date of grant were estimated using the Black-Scholes model with the following weighted average assumptions:

	Three Months Ended June 30,
	2004		2003
Expected life (years)	3		3
Interest rate	2.53	%	1.59	%
Volatility	.734		.585

6. Comprehensive Income (Loss)

Total comprehensive loss for the three and six month periods ended June 30, 2004 amounted to $254,000 and $607,000, respectively, as compared to total comprehensive income of $201,000 and $205,000 in the three and six month periods ended June 30, 2003. Comprehensive income (loss) is comprised of net income (loss) plus the increase/decrease in

currency translation adjustment.

7. Inventories

Inventories are stated at the lower of cost or market using the first-in, first-out (FIFO) method and consist of the following (in thousands):

	June 30, 2004		December 31, 2003
Raw materials	$	619	$	668
Work in progress	169		70
Finished goods	360		147
	$	1,148	$	885

At June 30, 2004 and December 31, 2003, inventories are stated net of a reserve of $804,000 and $806,000, respectively, for potentially obsolete inventory.

8. Revenue Recognition

The Company records revenue from the sale of TMR kits at the time of shipment to Edwards. TMR kit revenues include the amount invoiced to Edwards for kits shipped pursuant to written purchase orders received, as well as an amortized portion of deferred revenue related to Edwards’ lump sum TMR kit prepayment received in February 2004. The Company expects to amortize the prepayment into its consolidated statement of operations as revenue over the next seven years under the units-of-revenue method as prescribed by Emerging Issues Task Force (EITF) 88-18, Sales of Future Revenue. For the three and six months ended June 30, 2004, the Company has recorded amortization of $57,000 and $72,000, respectively.

Lasers are billed to Edwards in accordance with purchase orders that the Company receives. Invoiced lasers are recorded as other current assets and deferred revenue on the Company’s consolidated balance sheet until such time as the laser is shipped to a hospital, at which time the Company records revenue and cost of revenue.

Under the terms of the Edwards TMR distribution agreement, once Edwards has recovered a prescribed amount of revenue from a hospital for the use or purchase of a laser, any additional revenues earned by Edwards are shared with the Company pursuant to a formula established in the distribution agreement. The Company only records its share of such additional revenue, if any, at the time the revenue is earned.

The Company records revenue from the sale of TMR kits and lasers to international distributors or hospitals at the time of shipment.

Prior to entering into the Edwards TMR distribution agreement, the Company installed lasers in hospitals under placement contracts that did not transfer substantial ownership of the equipment to the customer. Revenues from these transactions are recognized over the life of the placement agreement in accordance with the specific terms of the contract.

Revenues from service and maintenance contracts are recognized ratably over the life of the contract.

Installation revenues related to a laser transaction are recorded as a component of placement and service fees when the laser is installed.

9. Warranty and Preventative Maintenance Costs

The Company warranties its products against manufacturing defects under normal use and service during the warranty period. The Company obtains similar warranties from a majority of its suppliers, including those who supply critical Heart Laser System components. In addition, under the terms of our TMR distribution agreement with Edwards, the Company is able to bill Edwards for actual warranty costs, including preventative maintenance services, up to a specified amount during the warranty period.

The Company evaluates the estimated future unrecoverable costs of warranty and preventative maintenance services for its installed base of lasers on a quarterly basis and adjusts its warranty reserve accordingly. The Company considers all available evidence, including historical experience and information obtained from supplier audits.

Changes in the warranty accrual were as follows (in thousands):

	Six Months Ended June 30,
	2004			2003
Balance, beginning of period	$	60,000		$	100,000
Payments made	—			—
Change in liability for warranties issued during the year	7			—
Change in liability for preexisting warranties	(7		)	—

Balance, end of period	$	60,000		$	100,000

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

This quarterly report (including certain information incorporated herein by reference) contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Statements containing terms such as “believes”, “plans”, “expects”, “anticipates”, “intends”, “estimates” and similar expressions contain uncertainty and are forward-looking statements. Forward-looking statements are based on current plans and expectations and involve known and unknown important risks and uncertainties that could cause actual results to differ materially from those described in the forward-looking statements. Such important factors and uncertainties include, but are not limited to, those set forth below under the heading “Certain Factors that May Affect our Future Results” and elsewhere in this quarterly report.

Application of Critical Accounting Policies and Estimates

This management’s discussion and analysis of financial condition and results of operations is based on our condensed consolidated financial statements, which have been

prepared in accordance with accounting principles generally accepted in the United States. Our significant accounting policies are more fully described in Note 2 of the Notes to Consolidated Financial Statements as well as in “Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations – Critical Accounting Policies and Estimates”, each as contained in our Annual Report on Form 10-K for the year ended December 31, 2003. No significant changes were made to those policies during the three months ended June 30, 2004, other than an addition to the Company’s revenue recognition policy to account for Edwards’ prepayment of future TMR kit revenues in accordance with EITF 88-18, Sales of Future Revenues. The Company’s revenue recognition policy has been updated as follows:

Revenue Recognition

The Company records revenue from the sale of TMR kits and lasers to international distributors or hospitals at the time of shipment.

Revenues from service and maintenance contracts are recognized ratably over the life of the contract.

Installation revenues related to a laser transaction are recorded as a component of placement and service fees when the laser is installed.

Results of Operations

Results for the three and six months ended June 30, 2004 and 2003 and the related percent of revenues were as follows:

	Three Months Ended June 30,						Six Months Ended June 30,
	2004				2003		2004				2003
	$		%		$	%	$		%		$	%
	(dollars in thousands)

Total revenue	1,796		100		2,011	100	3,705		100		3,745	100
Total cost of revenues	747		42		624	31	1,513		41		1,265	34
Gross profit	1,049		58		1,387	69	2,192		59		2,480	66
Selling, general & administrative	866		48		975	48	1,856		50		1,831	49
Research & development	516		29		220	11	1,045		28		461	12
Income (loss) from operations	(333	)	(19	)	192	10	(709	)	(19	)	188	5
Other income	82		5		11	1	108		3		30	1
Net income (loss)	(251	)	(14	)	203	11	(601	)	(16	)	218	6

	Three Months Ended June 30,			Increase (decrease) over 2003				Six Months Ended June 30,			Increase (decrease) over 2003
	2004		2003	Increase (decrease) over 2003				2004		2003	Increase (decrease) over 2003
	$		$	$		%		$		$	$		%
	(dollars in thousands)

Product sales	1,354		1,578	(224	)	(14	)	2,885		2,984	(99	)	(3	)
Placement and service fees	442		433	9		2		820		761	59		8
Total revenues	1,796		2,011	(215	)	(11	)	3,705		3,745	(40	)	(1	)
Product cost of sales	575		499	76		15		1,165		1,024	141		14
Placement and service fees cost of sales	172		125	47		38		348		241	107		44
Total cost of revenues	747		624	123		20		1,513		1,265	248		20
Gross profit	1,049		1,387	(338	)	(24	)	2,192		2,480	(288	)	(12	)
Selling, general & administrative expenses	866		975	(109	)	(11	)	1,856		1,831	25		1
Research & development expenses	516		220	296		135		1,045		461	584		127
Total operating expenses	1,382		1,195	187		16		2,901		2,292	609		27
Other income	82		11	71		645		108		30	78		260
Net income (loss)	(251	)	203	(454	)	(224	)	(601	)	218	(819	)	(376	)

Product Sales

Product sales decreased $224,000 and $99,000 during the three and six months ended June 30, 2004, respectively, as compared to three and six months ended June 30, 2003.

The first factor, laser revenues, which is the largest component of product sales, decreased by $213,000 and $78,000, respectively, for the three and six month periods ended June 30, 2004 as compared to the three and six month periods ended June 30, 2003.

In the three months ended June 30, 2004, this decrease is attributable to a $93,000 decrease in domestic laser revenue and a $120,000 decrease in international laser revenue. Domestic laser revenue declined as a result of (1) a decrease in the revenue sharing earned under the TMR distribution agreement with Edwards and (2) a lower average selling price on domestic laser transactions. These factors causing a decline were offset in part by an increase in the number of domestic units sold. The decline in international laser revenue was a result of a decrease in the number of international units sold.

In the six months ended June 30, 2004, the decrease in laser revenue is primarily attributable to lower international laser revenue of $125,000. This decrease was offset in part by an increase in domestic laser revenue of $47,000, resulting from an increase in the number of domestic units sold, offset by a lower average selling price on laser transactions and a decrease in the revenue sharing earned under the TMR distribution agreement with Edwards.

The second factor, disposable TMR kit revenues, which is the second largest component of product sales, decreased by $38,000 and $72,000, respectively, for the three and six month periods ended June 30, 2004 as compared to the three and six month periods ended June 30, 2003.

In the three months ended June 30, 2004, the decrease is primarily related to a decrease in international disposable revenue stemming from a lower volume of kit shipments to international customers. This overall decrease was partially offset by higher domestic disposable revenue. The increase in domestic disposable revenue was the result of an increase in the number of TMR kits shipped to Edwards, offset by a reduced share of revenue on TMR kits. The reduced share of revenue on TMR kits is a result of a modification to the TMR distribution agreement in February 2004, whereby the Company’s share of revenue on TMR kits sold to hospitals was reduced to 36.5% of the customer generated revenue. The impact of this reduced share was offset in part by $57,000 of amortization of deferred revenue.

In the six months ended June 30, 2004, the decrease in disposable revenues is primarily related to (1) a decrease in the number of international TMR kits shipped to hospitals, (2) a decrease in the number of domestic TMR kits shipped to Edwards, and (3) a reduced share of revenue on TMR kits (as a result of the aforementioned modification to the TMR distribution agreement). The negative impact of these factors was offset in part by $72,000 of amortization of deferred revenue.

The third factor, other product sales, increased $27,000 and $51,000, respectively, for the three and six month periods ended June 30, 2004 compared to the three and six month periods ended June 30, 2003.

Placement and Service Fees

Placement and services fees increased $9,000 and $59,000 during the three and six months ended June 30, 2004, respectively, as compared to the three and six months ended June 30, 2003.

Placement fees declined $8,000 and $60,000, respectively, for the three and six month periods ended June 30, 2004 as compared to the three and six month periods ended June 30, 2003.

Domestic placement fees decreased $94,000 and $129,000 in the three and six months ended June 30, 2004. These decreases are attributable to a reduction in domestic placement fees associated with the Company’s older installed base of HL1’s. International placement fees increased $86,000 and $69,000 in the three and six months ended June 30, 2004 due to increased billings to HL2 placement contract customers.

Service fees increased $17,000 and $119,000, respectively, for the three and six month periods ended June 30, 2004 as compared to the three and six month periods ended June 30, 2003 due to more domestic lasers in service in 2004, which resulted in increased billings to Edwards for service contracts and other service related calls.

Gross Profit

Total gross profit for the three and six months ended June 30, 2004 was $1,049,000, or 58% of revenues, and $2,192,000, or 59% of revenues, respectively, as compared to $1,387,000, or 69% of revenues, and $2,480,000, or 66% of revenues, for the comparable periods in 2003. The lower gross margin dollars in the three and six months ended June 30, 2004 is due to (1) lower additional shared revenue on domestic laser transactions, (2) lower international laser revenue, (3) lower placement fees, (4) lower average domestic laser selling prices and (5) lower disposable revenue. These decreases were offset in part by (1) an increase in the number of lasers sold, and (2) increased other product sales.

Selling, General and Administrative Expenses

Selling, general and administrative expenditures were $866,000 and $1,856,000 for the three and six months ended June 30, 2004, a decrease of $109,000 and an increase of $25,000, respectively, when compared to expenditures of $975,000 and $1,831,000 in the three and six months ended June 30, 2003. The overall decrease in selling, general and administrative expenses in the three months ended June 30, 2004 as compared to the three months ended June 30, 2003, is primarily a result of decreased expenditures related to employee compensation, offset by increased legal and administrative fees. Selling, general and administrative expenses in the six months ended June 30, 2004 as compared to the six months ended June 30, 2003 did not change significantly.

Research and Development Expenses

Research and development expenditures were $516,000 and $1,045,000 for the three and six months ended June 30, 2004, increases of $296,000 and $584,000, respectively, when compared to $220,000 and $461,000 in the three and six months ended June 30, 2003. The increased expenditures were incurred in connection with the development of the Optimaze System and additional product development work on longer term research and development projects.

We expect to continue to incur significant new research and development expenditures in future quarters in pursuit of our business strategy to broaden and diversify our product portfolio beyond our current TMR offerings. In particular, we expect our 2004 third and fourth quarter research and development expenditures to increase in the aggregate approximately $1.0 million compared to the third and fourth quarters of 2003 as we complete the development of the Optimaze System and advance certain other longer term research and development projects.

Other Income

Other income for the three and six months ended June 30, 2004 includes proceeds from an insurance settlement. In addition, interest income increased in the three and six months ended June 30, 2004 as compared to the three and six months ended June 30, 2003 due to higher average cash balances.

Net Income (Loss)

The Company incurred a net loss in the three and six months ended June 30, 2004 as compared to net income in the three and six months ended June 30, 2003 due to higher operating expenses and lower gross margin dollars.

There was no provision for income tax for the three and six months ended June 30, 2004 or June 30, 2003 due to a net loss in 2004 and U.S. net operating loss carryforwards being available to reduce taxable income in 2003.

We expect to incur a net loss in the remaining two quarters of 2004, primarily as a result of our planned increased investment in research and development, as discussed above.

Kit Shipments

We view disposable kit shipments to end users by Edwards as an important metric in evaluating our business. We believe such kit shipments, although not a direct measure, are a reasonable indicator for the adoption of TMR as a therapy in the marketplace. Disposable kit shipments to end users during the three and six months ended June 30, 2004 and June 30, 2003 were as follows:

	Three Months Ended June 30,				Six Months Ended June 30,
	2004	% Increase (decrease) over 2003		2003	2004	% Increase (decrease) over 2003		2003

Domestic	502	(4	)%	524	884	(3	)%	907
International	1	(99	)%	85	46	(60	)%	115
Total	503	(17	)%	609	930	(9	)%	1,022

Liquidity and Capital Resources

At June 30, 2004, the Company had cash and cash equivalents of $10,251,000.

During the six-month period ended June 30, 2004, the Company recorded a net loss of $601,000. The net loss was offset by favorable working capital changes, primarily deferred revenue of $4,535,000 (receipt of funds from Edwards) accounts payable and accounts receivable partly offset by unfavorable working capital changes in prepaid expenses and inventory, which resulted in net cash provided by operating activities of approximately $3,898,000. Cash used in investing activities was approximately $104,000, consisting of an investment in equipment. Cash provided by financing activities was approximately $90,000, consisting of proceeds from the exercise of stock options and shares purchased under the employee stock purchase plan. The

Company believes that its existing cash resources will meet its working capital requirements through the next 12 months.

We are largely dependent on the success of Edwards’ sales and marketing efforts in the U.S. to continue to increase the installed base of HL2 lasers and substantially increase TMR procedural volumes and revenues. Should the installed base of HL2 lasers or TMR procedural volume not increase sufficiently, our liquidity and capital resources will be negatively impacted. Additionally, other unanticipated decreases in operating revenues or increases in expenses or further changes or delays in third-party reimbursement to healthcare providers using our products may adversely impact our cash position and require further cost reductions or the need to obtain additional financing. It is not certain that we, working with Edwards and our international distributors, will be successful in achieving broad commercial acceptance of the Heart Laser Systems, or that we will be able to operate profitably in the future on a consistent basis, if at all.

Some hospital customers prefer to acquire the Heart Laser Systems on a usage basis rather than as a capital equipment purchase. We believe this is the result of limitations many hospitals currently have on acquiring expensive capital equipment as well as competitive pressures in the marketplace. A usage business model may result in a longer recovery period for Edwards to recoup its investment in lasers it purchases from us. This could result in (1) a delay in our ability to receive additional shared revenue, if any, that we otherwise are entitled to receive under the terms of our distribution agreement with Edwards (see “Application of Critical Accounting Policies and Estimates — Revenue Recognition”) and (2) a delay in the purchase of new lasers by Edwards if its installed base of placement lasers under usage contracts are under-performing and it chooses to re-deploy these lasers to other new hospital sites in lieu of purchasing a new laser from us. Our cash position and our need for additional financing to fund operations will be dependent in part upon the number of hospitals that acquire Heart Laser Systems from Edwards on a usage basis and the number and frequency of TMR procedures performed by these hospitals. We cannot predict whether a usage based sales model will be successful, whether implemented by us or Edwards.

Furthermore, we have recently undertaken a new business strategy that involves broadening and diversifying our product portfolio beyond our current TMR offerings, by developing or acquiring new and innovative medical devices to address cardiac and vascular related markets. We believe this strategy will result in our incurring losses for at least the next 12 months as we increase our investments in both manufacturing and research and development staff and capital equipment necessary to pursue these new strategic initiatives, including, but not limited to, the Optimaze System. In addition to our anticipated increase in research and development expenditures, we expect our capital expenditures in the next 12 months to be in the range of $300,000 to $400,000. We cannot be certain that we will be successful in implementing our new business strategy or that future sales, if any, from these planned new products will recover the investments we plan to make. If we are unsuccessful in implementing our new business strategy, our liquidity and capital resources will be adversely affected and we may need to obtain additional financing.

There can be no assurance that, should we require additional financing, such financing will be available on terms and conditions acceptable to us. Should additional financing not be available on terms and conditions acceptable to us, additional actions may be required that could adversely impact our ability to continue to realize assets and satisfy liabilities in the normal course of business. The condensed consolidated financial statements set forth in this quarterly report do not include any adjustments to reflect the possible future effects of these uncertainties.

Off-Balance Sheet Arrangements

None.

Certain Factors that May Affect our Future Results

The risks and uncertainties described below are not the only risks we face. Additional risks and uncertainties not presently known to us or currently deemed immaterial may also impair our business operations. If any of the following risks actually occur, our financial condition and operating results could be materially adversely affected.

We expect to incur significant operating losses in the near future

We incurred a net loss in the quarter ended June 30, 2004. We expect to continue to incur net losses for at least the next 12 months as we increase our spending in the areas of manufacturing and research and development for the Optimaze System. Moreover, as we continue to pursue our new business strategy of acquiring or developing new medical devices to address cardiac and vascular related markets, we may continue to incur expenses that exceed the revenues we generate. We cannot provide any assurance that we will be successful with our new business strategy or that we will ever return to profitability.

Our company is currently dependent on one principal product line to generate revenues

We currently market one principal product line, which consists of two patented high-powered carbon dioxide lasers and related TMR disposable kits known as the Heart Laser Systems. Approximately 92% and 93%, respectively, of our revenues in the three and six months ended June 30, 2004 and 95% in the year ended December 31, 2003, were derived from the sales and service of our Heart Laser Systems. This absence of a diversified product line means that we are directly and materially impacted by changes in the market for Heart Laser Systems.

Our company is dependent on one principal customer

Pursuant to the terms of our TMR distribution agreement with Edwards, Edwards is our exclusive distributor for our HL2 and TMR kits in the United States. In addition, pursuant to the terms of our new distribution agreement with Edwards for the Optimaze System (as well as any other additional surgical products that we may develop for the treatment of atrial fibrillation, referred to as AF, or atrial flutter), Edwards is our exclusive worldwide distributor of those products. As a result of the TMR relationship, Edwards accounted for 85% and 87% of our total revenue in the three and six months ended June 30, 2004 and 89% in the year ended
December 31, 2003, respectively, and we expect Edwards to account for the significant majority of our revenue in the future. If our relationship with Edwards does not progress as anticipated, or if Edwards’ sales and marketing strategies fail to generate sales of our products in the future, our revenue will decrease significantly and our business, financial condition and results of operations will be seriously harmed.

Our company is dependent on certain suppliers

Some of the components for our Heart Laser Systems, most notably the power supply and certain optics and fabricated parts for the HL2, and certain components for the Optimaze System,

are only available from one supplier, and we have no assurance that we will be able to source any of our sole-sourced components from additional suppliers. We are dependent upon our sole suppliers to perform their obligations in a timely manner. In the past, we have experienced delays in product delivery from our sole suppliers and, because we do not have an alternative supplier to produce these products for us, we have little leverage to enforce timely delivery. Any delay in product delivery or other interruption in supply from these suppliers could prevent us from meeting our commercial demands for our products, which could have a material adverse effect on our business, financial condition and results of operations. Furthermore, we do not require significant quantities of any components because we produce a limited number of our products each year. Our low-quantity needs may not generate substantial revenue for our suppliers. Therefore, it may be difficult for us to continue our relationships with our current suppliers or establish relationships with additional suppliers on commercially reasonable terms, if at all, and such difficulties may seriously harm our business, financial condition and results of operations.

We must complete development of the Optimaze System and be able to manufacture it in required volumes at commercially reasonable costs

We must successfully complete development of the Optimaze System. We expect to outfit our facility with the necessary production and test equipment and train our employees on how to build the product. This will include the need to manufacture highly specialized disposable handpieces for which we have no comparable prior experience producing at any volume. Until such time as we become more proficient in these manufacturing methods, if ever, we may encounter problems related to:

• production yields;

• quality control;

• training;

• shortages of qualified personnel; and

• potential capacity constraints.

Such problems could severely affect our ability to adequately scale up production and meet demand for our products on a timely basis, which could harm our business, financial condition and results of operations.

We are dependent upon our key personnel and will need to hire additional key personnel in the near future

Our ability to operate our business successfully depends in significant part upon the retention and motivation of certain key technical, regulatory, production and managerial personnel and our ongoing ability to hire and retain additional qualified personnel in these areas. Competition for such personnel is intense, particularly in the Greater Boston area. We cannot be certain that we will be able to attract such personnel and the loss of any of our current key employees could have a significant adverse impact on our business.

Our company may be unable to raise needed funds

As of June 30, 2004, we had cash and cash equivalents totaling $10,251,000, which includes $4,533,333 received from our February 2004 transaction with Edwards. Based on our current operating plan, we anticipate that our existing capital resources should be sufficient to

meet our working capital requirements for at least the next 12 months. However, if our business does not progress in accordance with our current business plan, we may need to raise additional funds in the future. We may not be able to raise additional capital upon satisfactory terms, or at all, and our business, financial condition and results of operations could be materially and adversely affected. To the extent that we raise additional capital by issuing equity or convertible securities, ownership dilution to our stockholders will result. To the extent that we raise additional capital through the incurrence of debt, our activities may be restricted by the repayment obligations and other restrictive covenants related to the debt.

In order to compete effectively, our current and future products need to gain commercial acceptance

TMR and surgical ablation for cardiac arrhythmias are still both emerging technologies. Our current and planned future products may never achieve widespread commercial acceptance. To be successful, we need to:

• demonstrate to the medical community in general, and to heart surgeons and cardiologists in particular, that TMR and surgical tissue ablation for cardiac arrhythmias are procedures that are effective, relatively safe and cost effective;

• support third-party efforts to document the medical processes by which TMR procedures relieve angina and surgical tissue ablation cures cardiac arrhythmias;

• have more heart surgeons trained to perform TMR procedures using the Heart Laser Systems and surgical tissue ablation procedures using the Optimaze System, assuming the latter becomes commercially available in the future; and

• maintain and expand third-party reimbursement for both the TMR procedure and the use of surgical tissue ablation for the treatment of cardiac arrhythmias.

To date, only a limited number of heart surgeons have been trained in the use of TMR, and we are dependent on Edwards to expand related marketing and training efforts in the U.S. for the use of our current and planned future products.

Although the Heart Laser Systems have received FDA approval and the CE Mark, they have not yet received widespread commercial acceptance. In addition, although the Optimaze System has received FDA clearance, it has not yet secured the CE Mark and it is not yet ready for widespread commercialization. If we are unable to maintain regulatory clearances, secure the CE Mark for the Optimaze System or achieve widespread commercial acceptance of the Heart Laser Systems or the Optimaze System, our business, financial condition and results of operations will be materially and adversely affected.

Our competitor in TMR may obtain FDA approval to market a new device, the impact of which is uncertain on the future adoption rate of TMR

Our primary TMR competitor, CardioGenesis, is attempting to obtain FDA approval to market their “percutaneous” method of performing myocardial revascularization, known as PMR, which would provide a less invasive method of creating channels in the heart. If PMR can be shown to be safe and effective and is approved by the FDA, it would eliminate the need in certain

patients to make an incision in the chest, reducing costs and speeding recovery. It is unclear what impact, if any, an approval of a PMR device would have on the future adoption rate for TMR procedures. If PMR is approved, it could erode the potential TMR market which would have a material adverse effect on our business, financial condition and results of operations.

Rapid technological changes in our industry could make our products obsolete

Our industry is characterized by rapid technological change and intense competition. New technologies and products and new industry standards will develop at a rapid pace, which could make our current and future planned products obsolete. The advent of new devices and procedures and advances in new drugs and genetic engineering are especially concerning competitive threats. Our future success will depend upon our ability to develop and introduce product enhancements to address the needs of our customers. Material delays in introducing product enhancements may cause customers to forego purchases of our products and purchase those of our competitors.

Many potential competitors have substantially greater financial resources and are in a better financial position to exploit marketing and research and development opportunities. In addition, we are aware that other companies are developing or already have developed proprietary systems for the treatment of cardiac arrhythmias, and specifically AF, that may be safer, clinically more effective, easier and more cost effective to use and, in the case of percutaneous devices, less invasive than the system we are developing.

We must receive and maintain government clearances or approvals in order to market our products

Our products and our manufacturing activities are subject to extensive, rigorous and changing federal and state regulation in the U.S. and to similar regulatory requirements in other major international markets, including the European Union and Japan. These regulations and regulatory requirements are broad in scope and govern, among other things:

• product design and development;

• product testing;

• product labeling;

• product storage;

• premarket clearance and approval;

• advertising and promotion; and

• product sales and distribution.

Furthermore, regulatory authorities subject a marketed product, its manufacturer and the manufacturing facilities to continual review and periodic inspections. We will be subject to ongoing FDA requirements, including required submissions of safety and other post-market information and reports, registration requirements, Quality Systems regulations, and recordkeeping requirements. The FDA’s Quality Systems regulations include requirements relating to quality control and quality assurance, as well as the corresponding maintenance of records and documentation. Edwards, our distributor, depending on its activities, is also subject to certain requirements under the Federal Food, Drug, and Cosmetic Act and the regulations promulgated thereunder, and state laws and registration requirements covering the distribution of our products. Regulatory agencies may change existing requirements or adopt new requirements

or policies that could affect our regulatory responsibilities or the regulatory responsibilities of a distributor like Edwards. We may be slow to adapt or may not be able to adapt to these changes or new requirements.

Later discovery of previously unknown problems with our products, manufacturing processes, or our failure to comply with applicable regulatory requirements may result in enforcement actions by the FDA and other international regulatory authorities, including, but not limited to:

• warning letters;

• patient or physician notification;

• restrictions on our products or manufacturing processes;

• voluntary or mandatory recalls;

• product seizures;

• refusal to approve pending applications or supplements to approved applications that we submit;

• refusal to permit the import or export of our products;

• fines;

• injunctions;

• suspension or withdrawal of marketing approvals or clearances; and

• civil and criminal penalties.

Should any of these enforcement actions occur, our business, financial condition and results of operations could be materially and adversely affected.

To date, we have received the following regulatory approvals for our products:

Heart Laser Systems

United States — We received FDA approval to market the HL1 Heart Laser System in August 1998 and the HL2 Heart Laser System in January 2001. However, although we have received FDA approval, the FDA:

• has restricted the use of the Heart Laser Systems by not allowing us to market these products to treat patients whose condition is amenable to conventional treatments, such as heart bypass surgery, stenting and angioplasty; and

• could impose additional restrictions or reverse its ruling and prohibit use of the Heart Laser Systems at any time.

Europe — Although we have the ability to market our Heart Laser System in the European Union, individual members of the European Union could prohibit, and France has prohibited, commercial use of the Heart Laser Systems.

We received the CE Mark from the European Union for the HL1 and HL2 in March 1995 and February 2001, respectively. However:

• the European Union could impose additional restrictions or reverse its ruling and prohibit use of the Heart Laser Systems at any time; and

• other European Union countries could prohibit or restrict use of the Heart Laser Systems.

Japan — We cannot market our product in Japan until we receive government approval.

We believe that Japan represents the largest potential market for the Heart Laser Systems in Asia. Prior to marketing the Heart Laser Systems in Japan, we must receive approval from the Japanese government. This approval requires a clinical study in Japan with at least 60 patients. A study was completed in 1998 with the HL1. Although the results of this study have been submitted to the Japanese government, we do not know whether the clinical study will be sufficient or when, if ever, we will receive approval to sell the HL1 in Japan. In addition, it is unclear what impact the introduction of the HL2 into the U.S. and other international markets will have on our ability to market the HL1 in Japan.

Optimaze System

United States — The FDA has given clearance to the Optimaze System through the 510(k) premarket notification process with indications for use as a surgical instrument for coagulation of soft tissue, including cardiac tissue, in conjunction with or without endoscopic equipment in the contact or non contact mode in open or closed surgical procedures.

Although we have received clearance from the FDA only for the indications of use stated above, physicians, under the practice of medicine exception, may use the Optimaze System in any manner they choose in treating an individual patient, including using the device to treat patients with AF. However, neither we nor Edwards have conducted any clinical trials designed to obtain data to submit to the FDA for the purpose of obtaining a specific indication for use of the Optimaze System that would allow us to make claims or otherwise market this device for the treatment of AF. We are aware of at least one company which has indicated they have submitted data to the FDA in support of a labeling claim that, if clearance is obtained, would allow them to market their device for the treatment of AF.

In the event this company or other competitors are successful in obtaining specific indications of use for their devices in the treatment of AF, our cardiac ablation products and specifically the Optimaze System may be at a competitive marketing disadvantage until such time, if ever, that Edwards conducts a clinical trial, submits sufficient data to the FDA by means of a new 510(k) and obtains clearance to market the Optimaze System for the treatment of AF. We cannot provide any assurance that Edwards will ever conduct such a clinical trial or, if they do, that the data they obtain and submit to the FDA will be sufficient for the FDA to expand the current indications of use and provide clearance for the Optimaze System to be marketed for the treatment of AF. Also, we cannot assure you that even if such clearance is obtained, that it will be obtained in a timely enough fashion for our products to remain competitive in the marketplace.

Europe — The Optimaze System cannot be marketed in the EU until such time as it receives CE Mark approval. We need to complete and submit the relevant technical documentation to the appropriate certifying body in order to be able to apply the CE Mark that, if granted, will enable the product to be distributed in the EU.

Changes in third party reimbursement for our TMR procedure could materially affect future demand for our TMR products

Currently, Medicare and Blue Cross Blue Shield provide coverage for TMR when it is performed as both a sole therapy treatment and when used as an adjunct to bypass surgery. Certain other private insurance companies and health maintenance organizations also currently provide reimbursement for these TMR procedures performed with our products and physician reimbursement codes have been established for both surgical procedures; however, we have limited data as to the breadth of this coverage for the TMR procedures by private insurance companies and health maintenance organizations. Should third party insurance reimbursement for our TMR products be reduced or eliminated in the future, our business, financial condition and results of operations would be materially and adversely affected.

In July 2004, the Centers for Medicare and Medicaid Services (CMS) convened the Medicare Coverage Advisory Committee (MCAC) to review and discuss the evidence and clinical data regarding TMR. The MCAC is an advisory panel consisting of clinicians and other medical experts which CMS utilizes to supplement their own internal expertise. Although the MCAC was not convened for the purpose of making a reimbursement coverage recommendation, we believe CMS is likely to review the information presented at the MCAC meeting and decide among the following options: (1) continue existing Medicare coverage for TMR without any modification, (2) issue new guidelines clarifying the patient criteria for Medicare reimbursement, (3) reduce or modify the existing reimbursement coverage for TMR, (4) eliminate reimbursement coverage for TMR altogether, or (5) request additional clinical studies to be performed. We believe the most likely course of action CMS will take is to issue new guidelines clarifying the patient criteria for Medicare reimbursement of TMR and request additional clinical studies to be performed. However, no assurance can be given that CMS will choose this course of action or not adopt another outcome.

Asserting and defending intellectual property rights may impact our results of operations

In our industry, competitors often assert intellectual property infringement claims against one another. The success of our business depends on our ability to successfully defend our intellectual property. Future litigation may have a material impact on our financial condition even if we are successful in marketing our products. We may not be successful in defending or asserting our intellectual property rights.

An adverse outcome in any litigation or interference proceeding could subject us to significant liabilities to third parties and require us to cease using the technology that is at issue or to license the technology from third parties. In addition, a finding that any of our intellectual property is invalid could allow our competitors to more easily and cost-effectively compete with us. Thus, an unfavorable outcome in any patent litigation or interference proceeding could have a material adverse effect on our business, financial condition or results of operations.

The cost to us of any patent litigation or interference proceeding could be substantial. Uncertainties resulting from the initiation and continuation of patent litigation or interference proceedings could have a material adverse effect on our ability to compete in the marketplace. Patent litigation and interference proceedings may also absorb significant management time.

We may be subject to product liability lawsuits; our insurance may not be sufficient to cover damages

We may be subject to product liability claims. The United States Supreme Court has stated that compliance with FDA regulations will not shield a company from common law negligent design claims or manufacturing and labeling claims based on state rules. Such claims may absorb significant management time and could degrade our reputation and the marketability of our products. If product liability claims are made with respect to our products, we may need to recall the implicated product which could have a material adverse effect on our business, financial condition and results of operations. In addition, although we maintain product liability insurance, we cannot be sure that our insurance will be adequate to cover potential product liability lawsuits. Our insurance is expensive and in the future may not be available on acceptable terms, if at all. If a successful product liability claim or series of claims exceeds our insurance coverage, it could have a material adverse effect on our business, financial condition and results of operations.

We are subject to risks associated with international operations

A portion of our product sales are generated from operations outside of the U.S. Establishing, maintaining and expanding international sales can be expensive. Managing and overseeing foreign operations may be difficult and products may not receive market acceptance. Risks of doing business outside the U.S. include, but are not limited to, the following: agreements may be difficult to enforce and receivables difficult to collect through a foreign country’s legal system; foreign customers may have longer payment cycles; foreign countries may impose additional withholding taxes or otherwise tax our foreign income, impose tariffs or adopt other restrictions on foreign trade; U.S. export licenses may be difficult to obtain; and the protection of intellectual property rights in foreign countries may be more difficult to enforce. There can be no assurance that our international business will grow or that any of the foregoing risks will not result in a material adverse effect on our business or results of operations.

Because we are incorporated in Canada, you may not be able to enforce judgments against us and our Canadian directors

Under Canadian law, you may not be able to enforce a judgment issued by courts in the U.S. against us or our Canadian directors. The status of the law in Canada is unclear as to whether a U.S. citizen can enforce a judgment from a U.S. court in Canada for violations of U.S. securities laws. A separate suit may need to be brought directly in Canada.

Our stock price has historically fluctuated and may continue to fluctuate significantly in the future which may result in losses for our investors

Our stock price has been and may continue to be volatile. Some of the factors that can affect our stock price are:

• the announcement of new products, services or technological innovations by us or our competitors;

• actual or anticipated quarterly increases or decreases in revenue, gross margin or earnings, and changes in our business, operations or prospects;

• speculation or actual news announcements in the media or industry trade journals

about our company, our products, the TMR procedure or changes in reimbursement policies by Medicare and/or private insurance companies;

• announcements relating to strategic relationships or mergers;

• conditions or trends in the medical device industry;

• changes in the economic performance or market valuations of other medical device companies; and

• general market conditions or domestic or international macroeconomic and geopolitical factors unrelated to our performance.

The market price of our stock may fall if shareholders sell their stock

Certain current shareholders hold large amounts of our stock, which they could sell in the public market from time to time. Sales of a substantial number of shares of our common stock within a short period of time could cause our stock price to fall. In addition, the sale of these shares could impair our ability to raise capital through the sale of additional stock.

We have no intention to pay dividends

We have never paid any cash dividends on our common stock. We currently intend to retain all future earnings, if any, for use in our business and do not expect to pay any dividends in the foreseeable future.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

A portion of our operations consists of sales activities in foreign jurisdictions. We manufacture our products exclusively in the U.S. and sell our products in the U.S. and abroad. As a result, our financial results could be affected by factors such as changes in foreign currency exchange rates or weak economic conditions in the foreign markets in which we distribute our products. Our operating results are exposed to changes in exchange rates between the U.S. dollar and foreign currencies, especially the Swiss Franc and the Euro. When the U.S. dollar strengthens against the Franc or Euro, the value of foreign sales decreases. When the U.S. dollar weakens, the functional currency amount of sales increases. No assurance can be given that foreign currency fluctuations in the future may not adversely affect our business, financial condition and results of operations, although at the present we do not believe that our exposure is significant.

The Company does not hedge any balance sheet exposures and intercompany balances against future movements in foreign exchange rates. We do not believe that a 10% change to the applicable exchange rates would have a material impact on our future results of operations or cash flows. However, the Company’s sensitivity analysis of the effects of changes in foreign currency exchange rates in such magnitude does not factor in a potential change in sales levels or local prices for its products as a result of the currency fluctuations or otherwise.

Our interest income is sensitive to changes in the general level of U.S. and foreign interest rates. In this regard, changes in U.S. and foreign interest rates affect the interest earned on our cash and cash equivalents. We do not believe that a 10% change to interest rates would have a material impact on our future results of operations or cash flows.

Item 4. Controls and Procedures

Our management, with the participation of our Chief Executive Officer, or CEO, and Chief Financial Officer, or CFO, evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act) as of June 30, 2004. Based on this evaluation, our CEO and CFO concluded that, as of June 30, 2004, our disclosure controls and procedures were (1) designed to ensure that material information relating to us, including our consolidated subsidiaries, is made known to our CEO and CFO by others within those entities, particularly during the period in which this report was being prepared and (2) effective, in that they provide reasonable assurance that information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms.

No change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act) occurred during the fiscal quarter ended June 30, 2004 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

Part II. Other Information

Item 4. Submission of Matters to a Vote of Security Holders

On May 19, 2004, the Company held its 2004 Annual Meeting of Shareholders (the “Shareholders Meeting”). At the Shareholders Meeting, the following matters were approved by the vote specified below:

1. Donald E. Bobo, Jr., Edward H. Pendergast, Robert I. Rudko, Ph.D. and Mark R. Tauscher were elected as Class I directors and will hold office until the annual meeting of shareholders in 2007 or until their successors are duly elected and qualified. Mr. Pendergast was subsequently reclassified as a Class II director and will hold office until the annual meeting of shareholders in 2006 or until his successor is duly elected and qualified. Mr. Bobo received 27,849,299 shares of common stock voting in favor of his election and 370,072 shares of common stock were withheld. Mr. Pendergast received 27,848,540 shares of common stock voting in favor of his election and 370,831 shares of common stock were withheld. Dr. Rudko received 27,816,208 shares of common stock voting in favor of his election and 403,163 shares of common stock were withheld. Mr. Tauscher received 27,827,737 shares of common stock voting in favor of his election and 391,634 shares of common stock were withheld. In addition, the terms of the following other directors continued after the Shareholders Meeting: Kevin J. Dunn, H.B. Brent Norton, M.D., Benjamin L. Holmes and Alan H. Magazine.

2. The ratification of the appointment of Ernst & Young LLP as the Company’s independent auditors for the year ending December 31, 2004 was approved. The votes were cast as follows: 28,025,894 shares of common stock were voted for the ratification, 147,044 shares of common stock were voted against the ratification and 46,434 shares of common stock abstained from the vote.

Item 6. Exhibits and Reports on Form 8-K

a) Exhibits

10.1	Form of Stock Option Grant Letter to Employees of the Registrant under the Registrant’s 1995 Stock Option Plan, 1997 Executive Stock Option Plan, 2000 Equity Incentive Plan and 2000 Non-Qualified Performance and Retention Plan.

31.1	Certification of Chief Executive Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2	Certification of Chief Financial Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1	Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

b) Reports on Form 8-K

None.

SIGNATURES

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

		PLC SYSTEMS INC.

Date:	August 11, 2004	By:	/s/ James G. Thomasch
			James G. Thomasch
			Chief Financial Officer
			(Principal Financial Officer and Chief Accounting Officer)

EXHIBIT INDEX

Exhibit Number		Description of Document

10.1		Form of Stock Option Grant Letter to Employees of the Registrant under the Registrant’s 1995 Stock Option Plan, 1997 Executive Stock Option Plan, 2000 Equity Incentive Plan and 2000 Non-Qualified Performance and Retention Plan.

31.1		Certification of Chief Executive Officer pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Certification of Chief Financial Officer pursuant to Rule 13a-14(a) or 15d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1		Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.