WASHINGTON, D. C. 20459

 

FORM 10-Q

 

QUARTERLY REPORT UNDER SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

 

FOR THE QUARTER ENDED September 30, 2004

 

COMMISSION FILE NUMBER 0-20970

 

VISION-SCIENCES, INC.

(Exact name of registrant as specified in its charter)

 

 

 

(508) 650-9971

(Registrant’s telephone number, including area code)

 

None

(Former name, former address, and former fiscal year if changed since last report)

 

 

                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 requirement 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 October 31, 2004.

 

 

VISION-SCIENCES, INC.

TABLE OF CONTENTS

 

Part I.	Financial Information	Page
	Item 1. Financial Statements
	Consolidated Balance Sheets	3
	Consolidated Statements of Operations	4
	Consolidated Statement of Stockholders’ Equity	5
	Consolidated Statements of Cash Flows	6
	Notes to Consolidated Financial Statements	7-12
	Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations	13-24
	Item 3. Quantitative and Qualitative Disclosures about Market Risk	24
	Item 4. Controls and Procedures	25
Part II.	Other Information
	Item 4. Submission of Matters to a Vote of Stockholders	26
	Item 5. Other Information	26
	Item 6. Exhibits and Reports on Form 8-K	26
	Signatures	27
	Exhibits	28-30

 

 

2

 

PART I - FINANCIAL INFORMATION

Item 1: FINANCIAL STATEMENTS

 

VISION-SCIENCES, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(Unaudited)

 

		September 30,			March 31,
		2004			2004
ASSETS
Current Assets:
Cash and cash equivalents		$	1,717,046		$	2,714,941
Accounts receivable, net of allowance for doubtful accounts of $66,679 and $52,800, respectively		1,044,749			1,683,459
Inventories		1,755,935			1,352,716
Prepaid expenses and deposits		62,732			62,182
Total current assets		4,580,462			5,813,298
Property and Equipment, at cost:
Machinery and equipment		3,896,553			3,623,854
Furniture and fixtures		242,071			212,002
Leasehold improvements		569,604			473,411
		4,708,228			4,309,267
Less-Accumulated depreciation and amortization		3,849,405			3,728,242
		858,823			581,025
Advance to Three BY Ltd		267,500			267,500
Other assets, net of accumulated amortization of $50,614 and $47,428, respectively		78,002			66,751
Total assets		$	5,784,787		$	6,728,574
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current Liabilities:
Acceptances payable to a bank		$	56,144		$	51,766
Current portion of note payable		18,379			17,495
Accounts payable		697,248			681,998
Accrued expenses		852,974			970,755
Total current liabilities		1,624,745			1,722,014
Long term portion of note payable		31,198			40,614
Stockholders’ Equity:
Common stock, $.01 par value—
Authorized—50,000,000 shares
Issued and outstanding—30,942,463 shares at September 30, 2004 and 30,687,963 shares at March 31, 2004		309,424			306,879
Additional paid-in capital		65,016,725			64,649,956
Accumulated deficit		(61,197,305		)	(59,990,889		)
Total stockholders’ equity		4,128,844			4,965,946
Total liabilities and stockholders’ equity		$	5,784,787		$	6,728,574

 

 

See accompanying notes to consolidated financial statements.

 

3

 

VISION-SCIENCES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

 

		Three Months Ended								Six Months Ended
		September 30,								September 30,
		2004				2003				2004				2003
Net sales		$	2,031,438			$	2,106,754			$	4,808,219			$	4,067,237
Cost of sales		1,780,599				1,304,769				3,474,815				2,507,666
Gross profit		250,839				801,985				1,333,404				1,559,571
Selling, general and administrative expenses (1)		844,622				936,327				1,841,057				1,807,752
Research and development expenses (1)		308,548				135,695				648,743				295,334
Stock-based compensation		33,526				579,235				67,052				634,988
Loss from operations		(935,857			)	(849,272			)	(1,223,448			)	(1,178,503			)
Interest income		7,389				6,541				16,074				14,713
Interest expense		(1,298			)	—				(2,701			)	—
Other income, net		—				3,625				3,659				7,236
Net loss		$		(929,766	)	$		(839,106	)	$	(1,206,416		)	$	(1,156,554		)
Basic and diluted net loss per common share		$		(0.03	)	$	(0.03		)	$		(0.04	)	$		(0.04	)
Shares used in computing basic and diluted net loss per common share		30,925,047				30,138,269				30,880,365				30,063,148

 

 

                        (1)    Excludes non-cash stock-based compensation, as follows:

 

Research and development expenses		$	109		$	482,170		$	219		$	519,563
Selling, general and administrative expenses		33,417			97,065			66,833			115,425
Total		$	33,526		$	579,235		$	67,052		$	634,988

 

 

See accompanying notes to consolidated financial statements.

 

4

 

VISION-SCIENCES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY

(Unaudited)

 

		Common Stock
													Total				Total
		Number of		$ .01			Additional			Accumulated			Stockholders’				Comprehensive
		Shares		Par Value			Paid-in-Capital			Deficit			Equity				Loss
Balance, March 31, 2004		30,687,963		$	306,879		$	64,649,956		$	(59,990,889	)	$		4,965,946
Exercise of stock options, net		254,500		2,545			299,717			—			302,262
Compensation expense related to non-employee non-qualified stock options							60,458			—			60,458
Compensation expense related to employee non-qualified stock options							6,594						6,594
Net loss		—		—			—			(1,206,416		)	(1,206,416			)	$	(1,206,416	)
Total comprehensive loss																	$	(1,206,416	)
Balance September 30, 2004		30,942,463		$	309,424		$	65,016,725		$	(61,197,305	)	$	4,128,844

 

 

See accompanying notes to consolidated financial statements.

 

5

 

VISION-SCIENCES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

 

		Six Months Ended			Six Months Ended
		September 30, 2004			September 30, 2003
Cash flows from operating activities:
Net loss		$	(1,206,416	)	$	(1,156,554	)
Adjustments to reconcile net loss to net cash used for operating activities:
Depreciation and amortization		124,349			107,827
Stock compensation for non-qualified options		67,052			634,988
Changes in assets and liabilities:
Accounts receivable		638,710			(430,861		)
Inventories		(403,219		)	52,959
Prepaid expenses and deposits		(550		)	5,613
Accounts payable		15,250			178,400
Accrued expenses		(117,781		)	63,210
Net cash used for operating activities		(882,605		)	(544,418		)
Cash flows used for investing activities
Increase in marketable securities		—			(2,014,283		)
Purchase of property and equipment, net		(398,961		)	(50,633		)
Advance to Three BY Ltd.		—			(216,500		)
Increase in other assets		(14,437		)	—
Net cash used for investing activities		(413,398		)	(2,281,416		)
Cash flows provided by (used for) financing activities:
Payments on note payable for computer equipment		(8,532		)	—
Proceeds from acceptances payable to a bank		4,378			18,281
Proceeds from the sale of common stock, net		—			329,012
Exercise of stock options, net		302,262			110,061
Net cash provided by financing activities		298,108			457,354
Net decrease in cash and cash equivalents		(997,895		)	(2,368,480		)
Cash and cash equivalents, beginning of period		2,714,941			2,744,143
Cash and cash equivalents, end of period		$	1,717,046		$	375,663
Supplemental Disclosure of Cash Flow Information:
Cash paid during the period for interest		$	2,701		$	—
Supplemental Disclosure of Non-cash Items from Financing Activities:
Fair market value of non-qualified options granted in the period		$	241,832		$	1,411,550
Change in the fair market value of non-qualified options existing at the beginning of the period		$	—		$	627,452

 

 

See accompanying notes to consolidated financial statements.

 

 

6

 

 

VISION-SCIENCES, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

 

1.                                      Basis of Presentation

The consolidated financial statements included herein have been prepared by the Company in accordance with accounting principles generally accepted in the United States of America, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission and include, in the opinion of management, all adjustments (consisting only of normal and recurring adjustments) that the Company considers necessary for a fair presentation of such information.  Certain information and footnote disclosures normally included in financial statements have been condensed or omitted pursuant to such rules and regulations.  The Company believes, however, that its disclosures are adequate to make the information presented not misleading.  These consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in the Company’s latest annual report to stockholders.  The results for the interim periods presented are not necessarily indicative of results to be expected for the full fiscal year.

 

2.                                      Summary of Significant Accounting Policies

 

The accompanying consolidated financial statements reflect the application of certain accounting policies described below:

 

a.                                       Principles of Consolidation: The accompanying consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries.  All material intercompany accounts and transactions have been eliminated in consolidation.

 

b.                                      Cash Equivalents: Cash equivalents are carried at market value, which approximates amortized cost.  Cash equivalents are short-term, highly liquid investments with original maturities of less than three months.

 

c.                                       Marketable Securities: Marketable securities are carried at market value, which approximates amortized cost.  The Company has classified its investments in marketable securities as available-for-sale securities.  At September 30, 2004, the Company had no marketable securities.

 

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

 

		September 30,			March 31,
		2004			2004
					(audited)
Raw materials		$	1,032,862		$	726,221
Work-in-process		356,152			297,220
Finished goods		366,921			329,275
		$	1,755,935		$	1,352,716

 

Work-in-process and finished goods inventories consist of material, labor, and manufacturing overhead.

 

7

 

e.                                       Depreciation and Amortization: The Company provides for depreciation and amortization using the straight-line method in amounts that allocate the cost of the assets to operations over their estimated useful lives as follows:

 

			Estimated
Asset Classification			Useful Life
Machinery and Equipment			3-5 Years
Furniture and Fixtures			5 Years

 

Leasehold improvements are amortized over the shorter of their estimated useful lives or the lives of the leases.

 

f.                                         Basic and Diluted Net Loss Per Common Share: Basic and diluted net loss per common share is based on the weighted average number of common shares outstanding.  Shares of common stock issuable pursuant to outstanding stock options have not been considered, as their effect would be antidilutive.

 

g.                                      Revenue Recognition: The following must occur before the Company recognizes revenue: (1) persuasive evidence of an arrangement exists, (2) delivery has occurred or services have been rendered, (3) the price is fixed or determinable, (4) collectibility is reasonably assured and (5) the fair value of undelivered elements, if any, exists.  Generally, the Company does not enter into multiple element arrangements.  The Company follows EITF 01-9 to record the effect on sales of any rebates offered to customers.

 

h.                                      Foreign Currency Transactions: In accordance with Statement of Financial Accounting Standard (“SFAS”) No. 52, Foreign Currency Translation, the Company charges foreign currency exchange gains or losses, in connection with its purchases of products from vendors in Japan, to operations, and charges foreign exchange translation gains and losses to retained earnings.

 

i.                                          Income Taxes: The Company accounts for income taxes under the liability method in accordance with SFAS No. 109, Accounting for Income Taxes.  Under SFAS No. 109, deferred tax assets or liabilities are computed based upon the differences between the financial statement and income tax bases of assets and liabilities as measured by the enacted tax rates.

 

The Company has recorded a valuation allowance equal to its net deferred tax asset due to the uncertainty of realizing the benefit of this asset.

 

8

 

j.                                          Accounting for Derivative Instruments: The Company accounts for non-qualified stock option agreements issued to non-employees as equity instruments, in accordance with the provisions of Emerging Issues Task Force (“EITF”) 96-18.  In the three months ended June 30, 2004, the Company granted non-qualified options to purchase 100,000 shares of the Company’s Common Stock to a consultant, with a value of approximately $241,832.  This value was determined using the Black-Scholes option-pricing model.  The Company will recognize this amount in its operations ratably over a two-year period, according to the vesting schedule of the option.  In the three and six months ended September 30, 2004, the Company recognized $30,229 and $60,458, respectively of expense as stock-based compensation in the consolidated statement of operations.

k.                                       Employee Stock-based Compensation Arrangements: The Company accounts for its employee stock-based compensation arrangements using the intrinsic value method under the provisions of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and Financial Interpretation No. (“FIN”) 44.  The Company does not recognize stock-based employee compensation cost when the options granted have an exercise price equal to, or greater than, the market value of the underlying common stock on the date of the grant.  The Company does recognize stock-based employee compensation cost when the options granted have an exercise price less than the market value of the underlying common stock on the date of the grant.

In June 2003, the Company granted options to purchase 1,295,000 shares of common stock to its employees at an exercise price of $1.04 per share.  The fair market value of the common stock on the date of grant was $1.09 per share.  As a result, the Company has recognized compensation expense for the difference between the fair market value and the option price over the life of the options.  In the three and six months ended September 30, 2004, the Company recognized $3,297 and $6,594, respectively of expense as stock-based compensation in the consolidated statement of operations.

 

9

 

In accordance with the Financial Accounting Standards Board (FASB) Statement No. 148, Accounting for Stock-Based Compensation — Transition and Disclosure, beginning in the quarter ending March 31, 2003, the Company adopted the disclosure requirements of FASB No. 148.  Had compensation expense for all stock option grants to employees been determined under the fair value method at the grant dates, consistent with the method prescribed by SFAS No. 123, the Company’s net loss would have been increased to the pro forma amounts indicated as follows:

		Three Months Ended September 30,						Six Months Ended September 30,
		2004			2003			2004			2003
Net loss — as reported		$	(929,766	)	$	(839,106	)	$	(1,206,416	)	$	(1,156,554	)
Stock-based employee compensation — as reported		3,297			5,652			6,594			7,536
Pro forma stock-based employee compensation		(103,500		)	(69,000		)	(198,000		)	(138,000		)
Net loss — pro forma		$	(1,029,969	)	$	(902,454	)	$	(1,397,822	)	$	(1,287,018	)
Net loss per share — as reported		$	(.03	)	$	(.03	)	$	(.04	)	$	(.04	)
Stock-based employee compensation — as reported		—			—			—			—
Pro forma stock-based employee compensation		—			—			(.01		)	—
Net loss per share — pro forma		$	(.03	)	$	(.03	)	$	(.05	)	$	(.04	)

 

3.                                      Three BY Ltd.

 

In June 2003, the Company entered into a Contract Manufacturing Agreement, a Loan Agreement and a Pledge Agreement (collectively, the “3BY Agreements”) with Three BY Ltd., an Israeli company (“3BY”).  The 3BY Agreements provide for, among other things, the manufacture of certain of the Company’s products by 3BY, and a loan of up to $267,500 by the Company to 3BY for the purchase and installation of certain manufacturing equipment by 3BY, at 3BY’s facility, to be used to manufacture certain of the Company’s products.  As of December 31, 2003, the Company had advanced the complete loan.  3BY has completed the purchase and installation of the manufacturing equipment, and the Company began receiving commercial production from 3BY in the three months ending September 30, 2004.  The Company plans to take title to the manufacturing equipment and convert the advance to machinery and equipment in the three months ending December 31, 2004.

 

10

 

4.                                      Segment Information

 

The Company has three reportable segments — medical, industrial and corporate.  The medical segment designs, manufactures and sells EndoSheaths and sells endoscopes to users in the health care industry.  The industrial segment designs, manufactures and sells borescopes to a variety of users, primarily in the aircraft engine manufacturing and aircraft engine maintenance industries.  In addition, the industrial segment manufactures and repairs endoscopes for the medical segment.  The corporate segment consists of certain administrative expenses applicable to the Company as a whole.

 

All segments follow the accounting policies described in the summary of significant accounting policies.  The Company evaluates segment performance based upon operating income.  Identifiable assets are those used directly in the operations of each segment.  Corporate assets include cash, marketable securities and the assets of Vision-Sciences, Ltd.  Data regarding management’s view of the Company’s segments are provided in the following tables.

 

11

 

Three months ended September 30,		Medical			Industrial			Corporate			Adjustments			Total
2004
Sales to external customers		$	1,130,315		$	901,123		$	—		$	—		$	2,031,438
Intersegment sales		—			330,253			—			(330,253		)	—
Operating income (loss)		(615,701		)	(51,737		)	(268,419		)	—			(935,857		)
Interest income (expense), net		—			—			6,091			—			6,091
Depreciation and amortization		54,386			11,596			1,506			—			67,488
Advance to 3BY Ltd.		—			—			—			—			—
Other significant non-cash items:
Stock-based compensation		30,416			63			3,047			—			33,526
Expenditures for fixed assets		227,078			17,491			—			—			244,569
2003
Sales to external customers		$	1,399,598		$	707,156		$	—		$	—		$	2,106,754
Intersegment sales		—			409,833			—			(409,833		)	—
Operating income (loss)		16,853			3,758			(869,883		)	—			(849,272		)
Interest income (expense), net		—			—			6,541			—			6,541
Depreciation and amortization		42,277			10,062			—			—			52,339
Advance to 3BY Ltd.		146,522			—			—			—			146,522
Other significant non-cash items:
Stock-based compensation		321			107			578,807			—			579,235
Expenditures for fixed assets		30,520			262			—			—			30,782

 

Six months ended September 30,		Medical			Industrial			Corporate			Adjustments			Total
2004
Sales to external customers		$	3,107,645		$	1,700,574		$	—		$	—		$	4,808,219
Intersegment sales		—			977,214			—			(977,214		)	—
Operating income (loss)		(605,442		)	(31,443		)	(586,563		)	—			(1,223,448			)
Interest income (expense), net		—			—			13,373			—			13,373
Depreciation and amortization		98,769			22,568			3,012			—			124,349
Advance to 3BY Ltd.		—			—			—			—			—
Other significant non-cash items:		—			—			—			—			—
Stock-based compensation		60,832			126			6,094			—			67,052
Expenditures for fixed assets		376,811			22,150			—			—			398,961
Total assets		2,664,864			1,594,733			1,806,008			(280,818		)	5,784,787
2003
Sales to external customers		$	2,670,615		$	1,396,622		$	—		$	—		$	4,067,237
Intersegment sales		—			556,217			—			(556,217		)	—
Operating income (loss)		40,675			(20,771		)	(1,198,407		)	—			(1,178,503		)
Interest income (expense), net		—			—			14,713			—			14,713
Depreciation and amortization		87,808			20,019			—			—			107,827
Advance to 3BY Ltd.		216,500			—			—			—			216,500
Other significant non-cash items:
Stock-based compensation		429			143			634,416			—			634,988
Expenditures for fixed assets		49,121			1,512			—			—			50,633
Total assets		2,259,918			979,314			2,606,992			(221,980		)	5,624,244

 

 

12

 

Item 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Executive Summary

 

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of The Private Securities Litigation Reform Act of 1995.  Examples of forward-looking statements include statements about expectations about future financial results, future products and future sales of new and existing products, future expenditures, and capital resources to meet anticipated requirements.  Without limiting the foregoing, the words “believes”, “anticipates”, “plans”, “expects”, and similar expressions are intended to identify forward-looking statements.  These forward-looking statements involve risks and uncertainties, and our actual results may differ significantly from those discussed in the forward-looking statements. Factors that might cause such a difference include, but are not limited to, the availability of capital resources, the availability of third-party reimbursement, government regulation, the availability of supplies, competition, technological difficulties, the continuation of our contract with Medtronic Xomed, Inc., general economic conditions and other risks detailed in our most recent Annual Report on Form 10-K and any subsequent periodic filings made with the Securities and Exchange Commission.  We do not undertake an obligation to update our forward-looking statements to reflect future events or circumstances.

 

We develop, manufacture and sell flexible endoscope products for the medical device and industrial device markets.  We operate in three reporting segments, medical, industrial and corporate.

 

Medical Segment

 

The medical segment supplies flexible endoscopes and disposable Slide-On™ EndoSheath® Systems (“EndoSheaths”) to the Ear-Nose-Throat (“ENT”), gastrointestinal (“GI”), urology and pulmonary markets.  Health-care providers use EndoSheaths to cover the insertion tube of flexible endoscopes, such as ENT endoscopes, Trans-Nasal Esophagoscopes (“TNE”), sigmoidoscopes, cystoscopes and bronchoscopes.  We have designed the EndoSheaths to allow the health-care providers to process patients economically by permitting the providers to minimize reprocessing the endoscopes between procedures.  In addition, the EndoSheaths ensure a sterile insertion tube for each patient procedure.

 

Our strategy in the medical segment is comprised of three components: a) improve sales distribution, b) lower manufacturing costs and c) increase the number of new product offerings.

 

Sales Distribution

 

Since September 19, 2003 we have been distributing all of our products for the ENT markets in the U.S.A. and Canada through Medtronic Xomed, Inc. (“Medtronic Xomed”) as part of our exclusive distribution agreement (the “Medtronic Agreement”) with them. The initial term of the Medtronic Agreement is three years.  Thereafter, the Medtronic Agreement will be automatically renewed for successive one-year periods, unless terminated by either party upon advance written notice.  Under the Medtronic Agreement, we have granted Medtronic Xomed exclusive distribution rights in the United States and Canada to market and sell our ENT EndoSheaths, ENT endoscopes TNE endoscopes and TNE EndoSheaths to ENT practitioners.  As of July 2004 Medtronic Xomed completed the minimum purchase requirements for the initial twelve-month period of the term, ending in August 2004 (“Year 1”).

 

13

 

Under the Medtronic Agreement, in order to maintain its exclusive distribution rights, Medtronic Xomed is required to purchase at least 110% of the Year 1 unit volume of ENT EndoSheaths in Year 2.  Due to higher than expected inventory levels of ENT EndoSheaths at Medtronic Xomed at the end of Year 1, Medtronic Xomed is forecasting to purchase approximately 20,000 units of ENT EndoSheaths during the remaining six months of our fiscal year ending March 31, 2005 (“FY 05”), compared to approximately 125,800 units purchased by Medtronic Xomed in the first six months of FY 05.  If Medtronic Xomed continues to sell units to end users at their current rate, they would purchase significantly less ENT EndoSheaths from us than required under the Agreement to maintain exclusivity.  There can be no assurance that Medtronic Xomed will purchase the required units to maintain exclusivity.  As a result of the Medtronic Agreement, the success of our ENT product lines in the domestic market is substantially dependent upon the success of the marketing and sales activities of Medtronic Xomed over which we have limited control.  We continue to market and sell our GI and Urology product lines directly to those markets, and we have retained our own international network of distributors for all our medical product lines.

 

Cost Reduction

 

During FY 04 we decided we could reduce manufacturing costs by sub-contracting the manufacture of our EndoSheaths for the GI and ENT markets to 3BY, Ltd. (“3BY”), a company in Israel.  We realized a benefit of approximately $42,000 in the three months ended September 30, 2004 as we sold the first commercial lots of sigmoidoscope EndoSheaths that were manufactured by 3BY.  We also received our first commercial lots of ENT EndoSheaths from 3BY, and will realize a benefit from shipping those EndoSheaths in the three months ending December 31, 2004.  We are no longer manufacturing ENT EndoSheaths in our Natick facility.

 

New Products

 

In FY 04 we received clearance from the U.S. Food and Drug Administration, (“FDA”) to market a number of new products to the ENT market.  In general, we designed these products to allow the ENT physician to perform procedures in their offices, using their standard laryngoscopes, as opposed to the current practice of traveling to hospitals to use special ENT endoscopes to perform the procedures.  Under the current reimbursement procedures of the Centers for Medicare & Medicaid Services (“CMS”), a governmental agency under the U.S. Department of Health and Human Services, ENT physicians will receive higher reimbursements by performing the procedures in their offices than they receive when they perform them in a hospital.

 

In April 2004 we received clearance from the Food & Drug Administration to market our Flexible Cystoscope with Slide-On EndoSheath System, and plan to continue to introduce products during the twelve months ending March 31, 2005 (“FY 05”) that enhance the practice efficiency of physicians and also ensure a sterile insertion tube for each patient procedure.

 

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Industrial Segment

 

The industrial segment designs, manufactures and sells flexible endoscopes, termed borescopes, for industrial users, and manufactures and repairs flexible endoscopes for the medical segment.  The industrial segment users consist primarily of companies in the aircraft engine manufacturing and maintenance markets and the defense market.

 

Corporate Segment

 

The corporate segment consists of certain administrative and business development activities applicable to the company as a whole.

 

Critical Accounting Policies and Estimates

 

This discussion and analysis of our financial condition and results of operations is based upon our Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the United States.  See the Notes to the Consolidated Financial Statements included elsewhere herein.  Certain of our accounting policies require the application of judgment in selecting the appropriate assumptions for calculating financial estimates.  By their nature these judgments are subject to an inherent degree of uncertainty.  We periodically evaluate the judgments and estimates used for our critical accounting policies to ensure that such judgments and estimates are reasonable for our interim and year-end reporting requirements.  These judgments and estimates are based upon our historical experience, current trends and information available from other sources, as appropriate.  If different conditions result from those assumptions used in our judgment, the results could be materially different from our estimates.  Our critical accounting policies include the following:

 

Revenue Recognition

 

We recognize revenue in accordance with SEC Staff Accounting Bulletin No. 104, Revenue Recognition in Financial Statements (SAB 104) and EITF 00-21, Revenue Arrangements with Multiple Deliverables. These pronouncements require that five basic criteria must be met before revenue can be recognized: (1) persuasive evidence that an arrangement exists; (2) delivery has occurred or services rendered; (3) the fee is fixed and determinable; (4) collectibility is reasonably assured and (5) the fair value of undelivered elements, if any, exists.  Determination of criterion (4) is based on management’s judgment regarding the collectibility of invoices for products and services delivered to customers.  Should changes in conditions cause management to determine these criteria are not met for certain future transactions, revenue recognized for any reporting period could be adversely affected.

 

We recognize revenue in accordance with EITF 01-9, Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Products).  This pronouncement requires that a vendor recognize rebates as a reduction of revenue based on a systematic and rational allocation of the cost of honoring rebates earned and claimed to each of the underlying revenue transactions that result in progress by the customer toward earning the rebate.  Measurement of the total rebate is based on the

 

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estimated number of customers that will ultimately earn rebates under the offer.  Determination of the number of customers that will earn rebates and the amount of those rebates is based on management’s judgment.  If different conditions result from those assumptions used in our judgment, the results could be materially different from our estimates.

 

Non-qualified Options Issued to Non-employees

 

Effective March 31, 2004, we account for non-qualified options issued to non-employees as equity instruments, in accordance with the provisions of EITF 96-18.  Fair values for these non-qualified options are derived from pricing models that consider current market and contractual prices for the underlying financial instruments, as well as time value, yield curve and volatility factors underlying the positions.  Pricing models and their underlying assumptions impact the amount and timing of the value of these non-qualified options, and the use of different pricing models or assumptions could produce different financial results.  We use the Black-Scholes option-pricing model for determining the value of non-qualified options issued to non-employees, and we expense that value over the vesting period of the non-qualified options.

 

We account for certain non-qualified options granted to employees to purchase our common stock in accordance with SFAS No. 123, Accounting for Stock-Based Compensation.  If the fair market value of the underlying stock at the date of grant is greater than the option price, we recognize compensation expense for the difference between the market price and the option price over the vesting period of the options.

 

Income Taxes

 

Under our income tax policy, we record the estimated future tax effects of temporary differences between the tax bases of assets and liabilities and amounts recorded in the accompanying consolidated balance sheets, as well as operating loss and tax credit carryforwards.  The evaluation of the recoverability of any tax assets recorded on the balance sheet is subject to significant judgment.  We have provided valuation allowances for all our deferred tax assets to date.

 

Results of Operations

 

Net Sales

Q2 05 Compared to Q2 04

Net sales for the three months ended September 30, 2004 (“Q2 05”) were $2,031,438, a decrease of $75,316, or 4%, compared to the three-month period ended September 30, 2003 (“Q2 04”).  During Q2 05, net sales of the medical segment decreased by $269,283, or 19%, to $1,130,315, and net sales of the industrial segment increased by $193,967, or 27%, to $901,123, compared to Q2 04.  In the medical segment, the net sales and changes in net sales by market were as follows ($000’s):

 

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Market			Q2 05			Q2 04			Increase (Decrease)			Percent
ENT			$	910		$	1,174		$	(264	)	(22	)%
GI			77			146			(69		)	(47	)%
Urology			72			—			72			100	%
Pulmonary			—			19			(19		)	(100	)%
Other			71			61			10			16	%
Total			$	1,130		$	1,400		$	(270	)	(19	)%

 

Medical Sales — ENT Market

 

Net sales to the ENT market include products for domestic and international customers as follows:

 

ENT Market			Q2 05			Q2 04			Increase (Decrease)				Percent
Domestic			$	560		$	712		$		(152	)	(21	)%
International			350			462			(112			)	(24	)%
Total ENT			$	910		$	1,174		$	(264		)	(22	)%

 

We further delineate products sold to the domestic ENT market as follows:

 

ENT Products			Q2 05			Q2 04			Increase (Decrease)				Percent
Slide-On EndoSheaths			$	261		$	486		$		(225	)	(46	)%
Endoscopes			291			220			71				32	%
Other products			8			6			2				33	%
Total Domestic			$	560		$	712		$	(152		)	(21	)%

 

The primary reason for the decrease in net sales of ENT products to the domestic market was the completion in July 2004 by Medtronic Xomed of its minimum purchase requirements for Year 1 of the Medtronic Agreement.  As a result, Medtronic Xomed had higher than expected levels of inventory of ENT endoscopes and ENT Slide-On EndoSheaths (“ENT SOS”) at July 31, 2004, and did not purchase any of those products in August and September 2004.  Although we do expect to sell these products to Medtronic Xomed during the third and fourth quarters of FY 05, we expect these sales will be at a significantly slower rate than during the third and fourth quarters of FY 04.  The lower sales of these products were partially offset by the purchase by Medtronic Xomed of new products, including our diagnostic Trans-Nasal Esophagoscope (“TNE D”), our new ENT-1000 small diameter flexible endoscope and companion EndoSheaths for these endoscopes.

 

As a result of continuing discussions between us and Medtronic Xomed, we have initiated three programs designed to increase the rate of sale of ENT SOS.  Medtronic Xomed has assumed responsibility for two of these programs, and we have assumed responsibility for a third one with them, a rebate program.  As part of this rebate program we will grant Medtronic Xomed a cash rebate for sales of ENT SOS to new users who commit to large annual purchases of ENT SOS.  The rebate program is designed to continue for one year, will be renewable by mutual agreement and will vary with the price charged by Medtronic Xomed to individual users.  We are accounting for this rebate program under

 

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provisions of EITF 01-9, whereby for the three months ended September 30, 2004 we reduced sales by approximately $39,000 for the estimated potential rebate to be granted to Medtronic Xomed for sales by Medtronic Xomed after September 1, 2004 of ENT SOS that they had paid for, and were in their inventory on September 30, 2004.

 

We expect Medtronic Xomed to purchase approximately 20,000 units of ENT SOS during the third and fourth quarters of FY 05, for which we will record a sales reduction for the estimated rebate.  The amount to be rebated is based upon a sliding scale that ranges from $.02 to $1.17 per ENT SOS, or 0.3% to 19.0% of our standard unit price to Medtronic Xomed.

 

Under the Medtronic Agreement, in order to maintain its exclusive distribution rights, Medtronic Xomed is required to purchase at least 110% of the Year 1 unit volume of ENT EndoSheaths in Year 2.  There can be no assurance, however, that Medtronic Xomed will decide to maintain its exclusive distribution rights.  As a result of the Medtronic Agreement, the success of our domestic ENT product lines will continue to be substantially dependent upon the success of the marketing and sales activities of Medtronic Xomed, over which we have limited control.

 

Sales of the TNE D and ENT-1000 endoscopes and companion EndoSheaths totaled approximately $224,000 in Q2 05, and we expect unit and dollar sales of these products will be higher in the third and fourth quarters of FY 05, as we expect to benefit from Medtronic Xomed’s efforts to penetrate the market for these products.

 

We also expect to release new products, including our therapeutic TNE (“TNE Bx”) and Slide-On EndoSheath System.  Both the TNE D and TNE Bx are products designed to simplify the procedure, to increase the patient throughput and to allow ENT physicians to perform procedures in their offices using topical anesthetics, compared to having to perform the same procedures in hospitals where patients are consciously sedated.  Being able to see more patients, and under reimbursement procedures allowed by CMS, physicians can generate more revenue by performing these procedures in their offices, compared to in a hospital environment.  The reimbursement rates are greater for the physician, but less overall, as there is no reimbursement for the hospital.  Patients benefit also, as they avoid being consciously sedated and they experience the procedures with an insertion tube covered with our sterile EndoSheath.  These are new procedures for ENT physicians, and communicating the benefits of them to the ENT physician is time-consuming.  We believe our relationship with Medtronic Xomed is critical to the marketing and distribution process, as Medtronic Xomed possesses greater sales and marketing abilities than we have.

 

We further delineate products sold to the international ENT market as follows:

 

ENT Products			Q2 05				Q2 04				Increase (Decrease)				Percent
Slide-On EndoSheaths			$		237		$	347			$	(110		)	(32	)%
Endoscopes			113				115				(2			)	(2	)%
Other products			—				—				—				—	%
Total International			$	350			$		462		$		(112	)	(24	)%

 

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The decrease in net sales to international distributors is primarily due to lower unit volume of ENT SOS, offset partially by higher unit average selling prices.  Effective April 1, 2004 we increased prices approximately 8% for ENT SOS and 5% for ENT endoscopes.  Unit sales of ENT SOS to the international distributors were 36,214 in Q2 05, a decrease of 22,346 units, compared to sales in Q2 04.  Included in the units sold in Q2 05 were 200 units for the ENT-1000 endoscope, not available for sale in Q2 04.  The lower demand from our distributors in Europe was partially offset by higher demand from our distributor in Australia.  Some of this slower demand was due to seasonal factors and also to reduced purchasing power by medical facilities that had overspent in other areas of their budget.  We expect unit demand in Europe will recover, but there can be no assurance it will recover to the level experienced in FY 04.

 

Unit sales of ENT endoscopes in Q2 05 to international distributors were 27, compared to 33 in Q2 04.  Unit sales in Q2 05 included 10 units of the ENT-1000, not available for sale in Q2 04.  Sales of ENT endoscopes are dependent upon a variety of factors, including the timing requirements of end users, foreign exchange rates, sales promotions of international competitors and other factors.  During FY 05 we increased our marketing efforts by hosting symposiums for physicians where they can experience the benefits that our products can have on the efficiency of their practices and the protection our products offer patients.

 

In addition, we plan to continue to sign agreements favorable to us with distributors in countries where we do not have a presence.  However, there can be no assurance we will be able to consummate these agreements on terms that are beneficial to us.

 

Medical Sales — Other Markets

 

Net sales to the GI market declined in Q2 05, compared to Q2 04, due primarily to lower demand for our proprietary sigmoidoscope EndoSheaths due to the aging of the installed base of our sigmoidoscopes and the continued insufficiency of reimbursement rates to physicians to support the use of the products.  We expect this decline to continue during FY 05.

 

During Q1 05 we launched our new Flexible Cystoscope (“CST-2000”) with Slide-On EndoSheath System at the American Urological Association trade show.  In Q2 05, we shipped our CST-2000 endoscope and EndoSheaths to international distributors in the U.K., Australia and Scandinavia.  We believe the CST-2000 and EndoSheath System can significantly enhance the practice efficiency of urologists by allowing them to avoid the tedious and time-consuming reprocessing of conventional cystoscopes, and presents the significant benefit of a sterile insertion tube for each patient.  In addition, the use of our CST-2000 with Slide-On EndoSheath System avoids the need to reprocess endoscopes with harsh chemicals, one of which has been contraindicated for use on patients with bladder cancer.

 

Industrial Segment

The increase in net sales of the industrial segment was due to higher demand for new borescopes, offset partially by lower demand for repairs of borescopes.

 

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6 Months 05 Compared to 6 Months 04

Net sales for the six months ended September 30, 2004 (“6M 05”) were $4,808,219, an increase of $740,982, or 18%, compared to the six-month period ended September 30, 2003 (“6M 04”).  During 6M 05 net sales of the medical segment increased by $437,030, or 16% to $3,107,645, and net sales of the industrial segment increased by $303,952, or 22%, to $1,700,574, compared to 6M 04.  In the medical segment net sales and changes in net sales by market were as follows ($000’s):

 

Market			6M 05				6M 04			Increase (Decrease)				Percent
ENT			$	2,642			$	2,232		$		410		18	%
GI			171				298			(127			)	(43	)%
Urology			95				—			95				100	%
Pulmonary			6				32			(26			)	(81	)%
Other			194				109			85				78	%
Total			$		3,108		$	2,671		$	437			16	%

 

Medical Sales — ENT Market

 

Sales to the ENT market include products for domestic and international customers as follows:

 

ENT Market			6M 05				6M 04			Increase (Decrease)			Percent
Domestic			$	1,679			$	1,180		$	499		42	%
International			963				1,052			(89		)	(8	)%
Total ENT			$		2,642		$	2,232		$	410		18	%

 

We further delineate products sold to the domestic ENT market as follows:

 

ENT Products			6M 05				6M 04				Increase (Decrease)			Percent
Slide-On EndoSheaths			$		944		$		893		$	51		6	%
Endoscopes			627				287				340			118	%
Other products			108				—				108			100	%
Total Domestic			$	1,679			$	1,180			$	499		42	%

 

Net sales of ENT SOS were strong in the six months ended September 30, 2004, because during the fiscal quarter ended June 30, 2004 Medtronic Xomed made significant purchases under the Medtronic Agreement.  These purchases declined thereafter, as explained above.  The increase in net sales of endoscopes for the period reflects net sales in Q2 05 of our TNE D endoscope and our ENT-1000 endoscope, offset partially by lower net sales of our ENT-2000 endoscope to Medtronic Xomed, as discussed above.  The increase in net sales of other products reflects sales of products to ENT physicians for the diagnosis of swallowing disorders.

 

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