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EX-32 - CERTIFICATION CEO, CFO - COGENTIX MEDICAL INC /DE/ex32-1.htm
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EX-31.1 - CERTIFICATION CEO - COGENTIX MEDICAL INC /DE/ex31-1.htm


SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D. C. 20459
 
FORM 10-Q
 
(Mark One)
 
  x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended December 31, 2010
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 0-20970
 
VISION-SCIENCES, INC.
(Exact name of registrant as specified in its charter)
 
Delaware
13-3430173
(State or other jurisdiction of
incorporation or organization)
 
(IRS employer
identification number)
40 Ramland Road South, Orangeburg, NY
10962
(Address of principal executive offices)
(Zip code)
 
(845) 365-0600
(Registrant’s telephone number, including area code)
 
(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 x    No o
 
Indicate by check mark whether the Registrant has submitted electronically and posted on its corporate website, if any every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the Registrant was required to submit and post such files). Yes x  No  o

Indicate by check mark whether the registrant is a large accelerated filer, accelerated filer, non-accelerated filer, or smaller reporting company. See definitions of “accelerated filer”, “large accelerated filer”, and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer o
Accelerated filer o
Non-accelerated filer o
(Do not check if a smaller reporting company)
Smaller reporting company x
 
Indicate by check mark whether the registrant is a shell company (as defined by Rule 12b-2 of the Exchange Act).         Yes o    No x
 
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of February 9, 2011
 
Common Stock, par value of $0.01
44,711,045
(Title of Class)
(Number of Shares)

 
1

 

VISION-SCIENCES, INC.
TABLE OF CONTENTS
 
Part I.
Financial Information
 
 
Item 1.
Financial Statements
 
   
Condensed Consolidated Balance Sheets
3
   
Condensed Consolidated Statements of Operations
4
   
Condensed Consolidated Statement of Stockholders’ Equity (Deficit)
5
   
Condensed Consolidated Statements of Cash Flows
6
   
Notes to Condensed Consolidated Financial Statements
7
 
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
15
 
Item 3.
Quantitative and Qualitative Disclosures about Market Risk
27
 
Item 4.
Controls and Procedures
27
       
Part II.
Other Information
 
 
Item 1.
Legal Proceedings
28
 
Item 1A.
Risk Factors
28
 
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
28
 
Item 3.
Defaults Upon Senior Securities
28
 
Item 4.
(Removed and Reserved)
29
 
Item 5.
Other Information
29
 
Item 6.
Exhibits
29
 
Signatures
30
 
 
2

 
 
PART I—FINANCIAL INFORMATION
Item 1: Financial Statements
 
Vision-Sciences, Inc. and Subsidiaries
Condensed Consolidated Balance Sheets
(In thousands, except per share amounts)
 
   
December 31,
   
March 31,
 
   
2010
   
2010
 
ASSETS
 
(unaudited)
       
Current assets:
           
Cash and cash equivalents
  $ 1,208     $ 2,540  
Short-term investments
    -       447  
Accounts receivable, net of allowance for doubtful accounts of $144
         
and $347, respectively
    1,647       1,147  
Inventories, net
    5,996       4,175  
Prepaid expenses and other current assets
    166       886  
Total current assets
    9,017       9,195  
                 
Machinery and equipment
    4,440       3,584  
Furniture and fixtures
    226       225  
Leasehold improvements
    359       357  
Total property and equipment, at cost
    5,025       4,166  
Less—accumulated depreciation and amortization
    2,792       2,237  
Total property and equipment, net
    2,233       1,929  
Other assets, net of accumulated amortization of $88 and $84,
         
respectively
    75       79  
Deferred debt cost, net of accumulated amortization of $132
         
and $31, respectively
    312       296  
Total assets
  $ 11,637     $ 11,499  
                 
LIABILITIES AND STOCKHOLDERS' (DEFICIT) EQUITY
               
Current liabilities:
               
Capital lease obligations
  $ 65     $ 55  
Accounts payable
    1,903       867  
Accrued expenses
    816       984  
Accrued compensation
    679       1,107  
Advances from customers
    3,669       -  
Total current liabilities
    7,132       3,013  
Line of credit—related party
    5,000       2,500  
Capital lease obligations, net of current portion
    94       61  
Total liabilities
    12,226       5,574  
                 
Commitments and Contingencies (Note 6)
               
Stockholders’ (deficit) equity:
               
Preferred stock, $0.01 par value—
               
Authorized—5,000 shares
               
issued and outstanding—none
    -       -  
Common stock, $0.01 par value—
               
Authorized—75,000 shares
               
issued and outstanding—37,711 shares
         
and 36,856 shares, respectively
    377       369  
Additional paid-in capital
    83,506       81,968  
Accumulated deficit
    (84,472 )     (76,412 )
Total stockholders’ (deficit) equity
    (589 )     5,925  
Total liabilities and stockholders’ (deficit) equity
  $ 11,637     $ 11,499  
 
See accompanying notes to condensed consolidated financial statements.
 
 
3

 
 
Vision-Sciences, Inc. and Subsidiaries
Condensed Consolidated Statements of Operations
(In thousands, except per share amounts)
(Unaudited)
 
   
Three Months Ended
   
Nine Months Ended
 
   
December 31,
   
December 31,
 
   
2010
   
2009
   
2010
   
2009
 
                         
Net sales
  $ 2,715     $ 2,600     $ 7,671     $ 8,807  
Cost of sales
    1,906       2,250       5,532       7,204  
Gross profit
    809       350       2,139       1,603  
                                 
Selling, general, and administrative expenses
    2,599       2,919       7,872       8,108  
Research and development expenses
    655       659       1,984       2,342  
Loss from operations
    (2,445 )     (3,228 )     (7,717 )     (8,847 )
                                 
Interest income
    1       14       4       85  
Interest expense
    (91 )     (6 )     (235 )     (52 )
Debt cost expense
    (37 )     (12 )     (101 )     (12 )
Other, net
    -       -       (1 )     (28 )
Loss before provision for income taxes
    (2,572 )     (3,232 )     (8,050 )     (8,854 )
Income tax provision
    4       2       10       18  
Net loss
  $ (2,576 )   $ (3,234 )   $ (8,060 )   $ (8,872 )
                                 
Net loss per common share - basic and diluted
  $ (0.07 )   $ (0.09 )   $ (0.22 )   $ (0.24 )
                                 
Shares used in computing net loss
                               
per common share
    36,955       36,855       36,904       36,853  
 
See accompanying notes to condensed consolidated financial statements.
 
 
4

 
 
Vision-Sciences, Inc. and Subsidiaries
Condensed Consolidated Statements of Stockholders’ Equity (Deficit)
(In thousands, except per share amounts)
(Unaudited)

                           
Total
 
   
Common Stock
   
Additional
         
Stockholders’
 
   
Number
    $0.01    
Paid-in
   
Accumulated
   
Equity
 
   
of Shares
   
Par Value
   
Capital
   
Deficit
   
(Deficit)
 
Balance at March 31, 2009
    36,818     $ 368     $ 80,031     $ (63,988 )   $ 16,411  
Exercise of stock options
    38       1       42       -       43  
Issuance of stock warrants
    -       -       327       -       327  
Stock-based compensation expense
    -       -       1,568       -       1,568  
Net loss
    -       -       -       (12,424 )     (12,424 )
Balance at March 31, 2010
    36,856       369       81,968       (76,412 )     5,925  
Exercise of stock options
    100       1       111       -       112  
Issuance of stock warrants
    -       -       117       -       117  
Issuance of restricted stock awards
    755       7       -       -       7  
Stock-based compensation expense
    -       -       1,310       -       1,310  
Net loss
    -       -       -       (8,060 )     (8,060 )
Balance at December 31, 2010
    37,711     $ 377     $ 83,506     $ (84,472 )   $ (589 )
 
See accompanying notes to condensed consolidated financial statements.
 
 
5

 
 
Vision-Sciences, Inc. and Subsidiaries
Condensed Consolidated Statements of Cash Flows
(In thousands)
(Unaudited)
 
   
Nine Months Ended
 
   
December 31,
 
   
2010
   
2009
 
Cash flows from operating activities:
           
Net loss
  $ (8,060 )   $ (8,872 )
Adjustments to reconcile net loss to net cash used in operating activities:
               
Depreciation and amortization
    559       494  
Stock-based compensation expense
    1,310       1,177  
Issuance of restricted stock awards
    7       -  
Provision for (recovery of) bad debt expenses
    (152 )     52  
Debt cost expense
    101       12  
Loss on sale of investments
    -       34  
Changes in assets and liabilities:
               
Accounts receivable
    (348 )     522  
Inventories
    (2,372 )     224  
Prepaid expenses and other current assets
    720       (173 )
Other assets
    -       (23 )
Accounts payable
    1,036       (294 )
Accrued expenses
    (168 )     (22 )
Accrued compensation
    (428 )     131  
Advances from customers
    3,669       -  
Net cash used in operating activities
    (4,126 )     (6,738 )
Cash flows from investing activities:
               
Purchase of short-term investments
    (149 )     (2,572 )
Proceeds from short-term investment sales/maturities
    596       8,310  
Purchase of property and equipment
    (220 )     (601 )
Net cash provided by investing activities
    227       5,137  
Cash flows from financing activities:
               
Advance on line of credit—related party
    2,500       -  
Payments of capital leases
    (45 )     (31 )
Exercise of stock options
    112       43  
Net cash provided by financing activities
    2,567       12  
Net decrease in cash and cash equivalents
    (1,332 )     (1,589 )
Cash and cash equivalents from continuing operations, beginning of period
  $ 2,540     $ 1,975  
Cash and cash equivalents from discontinued operations, beginning of period
  $ -     $ 8  
Cash and cash equivalents from discontinued operations, end of period
  $ -     $ -  
Cash and cash equivalents from continuing operations, end of period
  $ 1,208     $ 394  
                 
Supplemental disclosure of cash flow information:
               
Cash paid during the period for:
               
Interest
  $ 58     $ -  
Income taxes
  $ 27     $ 18  
                 
Non-cash financing activities:
               
Transfers of inventory to fixed assets for use as demonstration equipment
  $ 551     $ -  
Capital lease entered into for equipment purchase
  $ 88     $ -  
Issuance of stock warrants with line of credit—related party
  $ 117     $ 221  
 
See accompanying notes to condensed consolidated financial statements.
 
 
6

 
 
Vision-Sciences, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited, in thousands except per share amounts)
 
Note 1.  Basis of Presentation
 
Vision-Sciences, Inc. and its Subsidiaries (the “Company” – which may be referred to as “our”, “us” or “we”) have prepared the condensed consolidated financial statements included herein according to generally accepted accounting principles in the United States of America (“U.S. GAAP”), without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”) and include, in the opinion of management, all adjustments that we consider necessary for a fair presentation of such information.  We have condensed or omitted certain information and footnote disclosures normally included in financial statements pursuant to those rules and regulations. We believe, however, that our disclosures are adequate to make the information presented not misleading. The results for the interim periods presented are not necessarily indicative of results to be expected for the full fiscal year. Please read these condensed consolidated financial statements in conjunction with the consolidated financial statements and the notes thereto included in our Annual Report on Form 10-K for the fiscal year ended March 31, 2010.

Note 2.  The Company and Summary of Significant Accounting Policies

Company Overview

We design, develop, manufacture, and market products for endoscopy - the science of using an instrument, known as an endoscope to provide minimally invasive access to areas not readily visible to the human eye. Our products are sold throughout the world through direct sales representatives in the United States and independent distributors for the rest of the world. Our largest geographic markets are the United States and Europe. Pursuant to our agreement dated as of September 22, 2010, with the Endoscopy Division of Stryker Corporation (“Stryker”), we will supply to Stryker our flexible video and fiber cystoscopes and related EndoSheath products upon launch by Stryker of such products (the “Stryker Agreement”) (See Note 9. Advances from Customers for additional information).

 We were incorporated in Delaware, and are the successor to operations originally begun in 1987. Machida Incorporated (“Machida”), which became our wholly-owned subsidiary in December 1990, designs, manufactures, and sells borescopes to a variety of users, primarily in the aircraft engine manufacturing and aircraft engine maintenance industries. Another one of our subsidiaries, Vision Sciences Ltd., an Israeli corporation, was established in 1998, but has been inactive since the fiscal year ended March 31, 2002. We own the registered trademarks Vision Sciences®, Slide-On®, EndoSheath®, and The Vision System®. Not all products referenced in this report are approved or cleared for sale, distribution, or use.

Liquidity and Capital Resources

We have incurred losses since our inception, and losses are expected to continue through at least fiscal years 2011 and 2012. We have funded the losses principally with cash flow from operations, advances under a three-year $5.0 million revolving loan agreement (the “Loan”) with our Chairman, Lewis C. Pell (the “Lender”), proceeds from public and private equity financings, payments from Medtronic related to the sale of certain assets related to our ENT EndoSheath technology business, and the sale of other assets. We have also received an aggregate of $3.9 million of deposits from two customers (the “Prepayments”) in September 2010 to support anticipated orders, which are expected to ship by June 30, 2011 (the end of the first quarter of our fiscal year 2012). In addition, on January 18, 2011, we issued 7 million shares of our common stock at a purchase price of $1.50 per share to a number of investors in a private placement for aggregate proceeds of $10.5 million (see Note 10. Subsequent Event for additional information). We believe that our cash, including the Prepayments, and the $10.5 million of proceeds we received from the private placement will be sufficient to fund our working capital, capital expenditures, and future operating losses until March 31, 2012. However, if our performance expectations fall short (including regaining sales or profits historically generated from Medtronic and generating expected sales from Stryker and SpineView) or our expenses exceed expectations, we will need to either secure additional financing or reduce expenses or a combination thereof. Our failure to do so would have a material adverse impact on our prospects and financial condition. There can be no assurance that any contemplated external financing will be available on terms acceptable to us, if at all, or that we will be able to reduce our expenses.
 
 
7

 

Summary of Significant Accounting Policies

Our condensed consolidated financial statements are prepared in accordance with U.S. GAAP. These accounting principles require us to make certain estimates, judgments and assumptions. We believe that the estimates, judgments and assumptions upon which we rely are reasonable, based upon information available to us at the time that these estimates, judgments and assumptions are made. These estimates, judgments and assumptions can affect the reported amounts of assets and liabilities as of the date of the financial statements as well as the reported amounts of revenues and expenses during the periods presented. To the extent there are any differences (other than nominal differences) between these estimates, judgments or assumptions and actual results, our financial statements will be affected. The accounting policies that reflect our more significant estimates, judgments, and assumptions and which we believe are the most critical to aid in fully understanding and evaluating our reported financial results include the following:

• Revenue recognition
• Stock-based compensation expense
• Allowances for doubtful accounts
• Inventory obsolescence reserves
• Other contingencies

The accompanying condensed consolidated financial statements reflect the accounts of the Company. All significant inter-company accounts and transactions have been eliminated in consolidation.

Accounting Standards Updates Not Yet Effective

In January 2010, the FASB issued Accounting Standards Update No. 2010-06 (“ASC Update 2010-06”), an update to ASC 820. This update provides amendments to add new requirements for disclosures about transfers into and out of Levels 1 and 2 and separate disclosures about purchases, sales, issuances, and settlements relating to Level 3 measurements. It also clarifies existing fair value disclosures about the level of disaggregation and about inputs and valuation techniques used to measure fair value. ASC Update 2010-06 became effective for us with the reporting period beginning January 1, 2010, except for the disclosure on the roll forward activities for Level 3 measurements, which will become effective for us with the reporting period beginning April 1, 2011 (our fiscal year 2012). We do not expect that the provisions of the update will have a material effect on our results of operations, financial position, or liquidity.

Note 3.  Basic and Diluted Net Loss per Common Share

Basic net loss per share is calculated by dividing the net loss by the weighted average number of common shares outstanding. For all periods presented, the diluted net loss per common share is the same as basic net loss per common share, as the inclusion of other shares of stock issuable pursuant to stock options and warrants would be anti-dilutive. Stock options, warrants, and restricted stock of 8,078,221 shares and 7,056,582 shares as of December 31, 2010 and 2009, respectively, were excluded from the calculation of fully diluted loss per share as their inclusion would have been anti-dilutive due to the net loss.

Note 4.  Inventories

Inventories are stated at the lower of cost or market using the first-in, first-out (“FIFO”) method and consist of the following:
 
   
December 31,
   
March 31,
 
   
2010
   
2010
 
Raw materials
  $ 4,520     $ 3,330  
Work in process
    787       269  
Finished goods
    689       576  
    $ 5,996     $ 4,175  
 
Raw materials include components purchased from independent suppliers. Most purchased components are available from multiple sources, with the exception of certain key components which are supplied to us by key suppliers, with whom we have long-term supply arrangements, but no long-term supply agreements.

Note 5.  Financial Instruments

Short-Term Investments

We classify investments with original maturities of greater than 90 days in certificates of deposit as short-term investments. We intend to hold these investments to maturity. Our short-term investments are carried at amortized cost in our condensed consolidated balance sheets.
 
 
8

 

The following table summarizes these securities classified as held to maturity.
 
   
December 31, 2010
   
March 31, 2010
 
   
Amortized
    Fair    
Amortized
    Fair  
Held to maturity less than one year:
 
Cost
   
Value
   
Cost
   
Value
 
Certificates of deposit
  $ -     $ -     $ 447     $ 446  
Total short-term investments
  $ -     $ -     $ 447     $ 446  
 
Fair Value Measurements

The carrying amounts reflected in our condensed consolidated balance sheets for cash and cash equivalents, accounts receivable, other current assets, accounts payable, accrued expenses, accrued compensation, and capital lease obligations approximate fair value due to their short-term nature. The fair value of the line of credit is based on its demand value, which is equal to its carrying value.

Note 6.  Commitments and Contingencies

Line of Credit – Related Party

On November 9, 2009, we entered into a Loan with the Lender. Any amounts drawn against the Loan (an “Advance”) accrue interest at an annual rate of 7.5%. The Lender received an availability fee equal to a per annum rate of 0.5% on the unused portion of the Loan calculated based on the difference between the average annual principal amount of the outstanding Advances under the Loan and the maximum advance of $5.0 million. The availability of advances under the Loan is subject to customary conditions. As of December 31, 2010, we had fully drawn down the Loan. Subject to the terms of the Loan, we will be required to prepay all amounts outstanding under the Loan upon a change of control of the Company. We were required to prepay part or all of the amounts outstanding if we secured other financing or consummate a sale or license of assets, in each case resulting in net proceeds to us of $5.0 million or greater. In connection with our recent private placement (see Note 10. Subsequent Event for additional information), we received a waiver from the Lender such that we will not be required to repay all or any portion of the Advances with the proceeds from this fund raising.

In connection with the Loan, the Lender received  a five-year warrant (the “Initial Warrant Shares”) to purchase up to 272,727 shares of our common stock at an exercise price of $1.375 per share (representing 7.5% warrant coverage, or approximately 0.7% of our outstanding common stock at the time of the Loan), which immediately vested upon issuance. In addition, we issued a second five-year warrant (the “Additional Warrant Shares”) to purchase up to an additional 378,788 shares of our common stock at an exercise price of $1.65 per share (representing up to an additional 12.5% warrant coverage, or approximately 1.0% of our then outstanding common stock) which vests at the time that each Advance is made in an amount equal to (i) the product of the amount of the Additional Warrant Shares multiplied by (ii) a ratio, (A) the numerator of which is the amount of the new Advance and (B) the denominator of which is $5.0 million. A portion of the Additional Warrant Shares vested on the date of the $2.5 million Advance on March 29, 2010, the $2.0 million Advance on June 29, 2010, and the $0.5 million Advance on December 16, 2010. All warrants are fully vested as of December 31, 2010.

The following table summarizes Advances taken on the Loan and warrant issuances:
 
         
Number of
   
Fair Value of
 
   
Amount of
   
Warrant Shares
   
Warrant Shares
 
Month
 
Advance
   
Vested
   
on Date Vested
 
December 2010
 
 $0.5 million
    37,879    
$30 thousand
 
June 2010
 
 $2.0 million
    151,515    
$87 thousand
 
March 2010
 
 $2.5 million
    189,394    
 $106 thousand
 
November 2009
 
n/a
    272,727    
 $221 thousand
 
 
On the date of issuance, the fair value of the Initial and Additional Warrant Shares was approximately $221 thousand and $249 thousand, respectively. We defer costs associated with securing a line-of-credit or revolving loan agreement over the applicable term. These costs are amortized as debt cost expense in our condensed consolidated statement of operations. Accordingly, we recorded the $221 thousand associated with the Initial Warrant Shares as a deferred debt cost asset with a corresponding amount as additional paid-in capital. The cost is being amortized on a straight-line basis over the three-year term of the Loan.
 
 
9

 

We recorded the fair value associated with the Additional Warrant Shares as a deferred debt cost asset with a corresponding amount as additional paid-in capital. The cost is being amortized over the remaining life of the Loan using the effective interest method. During the three and nine months ended December 31, 2010, we recorded approximately $37 thousand and $101 thousand, respectively, as debt cost expense related to the amortization of the deferred debt cost for the Initial and Additional Warrant Shares in our condensed consolidated statement of operations.

At December 31, 2010, we had $5.0 million in outstanding borrowings under the Loan, which is reflected as line of credit – related party on our condensed consolidated balance sheet. The $5.0 million revolving loan expires in November 2012, at which time we must repay all borrowings under the Loan. During the three and nine months ended December 31, 2010, we recorded approximately $89 thousand and $227 thousand, respectively, as interest expense related to the availability fee and accrued interest on outstanding borrowings in our condensed consolidated statement of operations. At December 31, 2010, we had $0.2 million in accrued interest related to the Loan, which is included in accounts payable ($0.1 million) and accrued expenses ($0.1 million) on our condensed consolidated balance sheet.

Note 7.  Stock-Based Awards
 
Stock Option Plans

We maintain the following equity incentive plans:

·  
The 2000 Stock Incentive Plan (the “2000 Plan”), approved by stockholders in August 2000, authorized the issuance of up to 4,500,000 shares of common stock covering several different types of awards, including stock options, restricted shares, stock appreciation rights, and performance shares.
·  
The 2007 Stock Incentive Plan (the “2007 Plan”), approved by stockholders in August 2007, authorized the issuance of up to 4,000,000 shares of common stock covering several different types of awards, including stock options, restricted shares, stock appreciation rights, and other stock-based awards. On July 12, 2010, our Board and on September 2, 2010, our stockholders approved an amendment to the 2007 Plan to increase the authorized shares issuable under the plan to 5,000,000 shares of common stock.
·  
The 2003 Director Option Plan (the “2003 Plan”), approved by stockholders in July 2003 and amended in August 2008, authorized the issuance of up to 450,000 shares of common stock covering the annual automatic grant of 10,000 stock options per outside director per year. The 2003 Plan also provides for granting newly elected or appointed outside directors a one-time grant of 10,000 stock options.

The stock option plans provide that options may be granted at an exercise price of 100% of fair market value of our common stock on the date of grant, may be exercised in full or in installments, at the discretion of our Board of Directors or its Compensation Committee, and must be exercised within ten years from date of grant. We recognize stock-based compensation expense on a straight-line basis over the requisite service period based on fair values, generally four years. We use historical data to estimate expected employee behaviors related to option exercises and forfeitures and included these expected forfeitures as a part of the estimate of stock-based compensation expense as of the grant date.

Stock-Based Compensation Expense
 
We account for stock-based awards issued to employees in accordance with the provisions of ASC 718 (Topic 718, Compensation – Stock Compensation). We recognize stock-based compensation expense on a straight-line uniform basis over the service period of the award, which is generally four years for employees. Stock-based awards issued to consultants are accounted for in accordance with the provisions of ASC 718 and ASC 505-50 (Subtopic 50 “Equity-Based Payments to Non-Employees” of Topic 505, Equity). Options granted to consultants are periodically revalued as the options vest, and are recognized as an expense over the related period of service or the vesting period, whichever is longer.

Stock-based compensation expense for the three and nine months ended December 31, 2010 and 2009 was recorded in our condensed consolidated statement of operations as follows:
 
   
Three Months Ended
   
Nine Months Ended
 
   
December 31,
   
December 31,
 
   
2010
   
2009
   
2010
   
2009
 
Cost of sales
  $ 48     $ 85     $ 185     $ 288  
Selling, general, and administrative expenses
    311       135       1,058       781  
Research and development expenses
    19       41       67       108  
  Total stock-based compensation expense
  $ 378     $ 261     $ 1,310     $ 1,177  
 
 
10

 
 
We estimated the fair value of the stock options granted on the date of grant using a Black-Scholes valuation model that used the weighted average assumptions noted in the following table. The risk-free interest rate assumption we use is based upon United States Treasury interest rates appropriate for the expected life of the awards. The expected life (estimated period of time that we expect employees, consultants and directors to hold their stock options) was estimated based on historical rates for two group classifications, (i) employees and consultants and (ii) outside directors. Expected volatility was based on historical volatility of our stock price for a period equal to the stock option’s expected life and calculated on a daily basis. The expected dividend rate is zero since we do not currently pay cash dividends on our common stock and do not anticipate doing so in the foreseeable future. Under the provisions of ASC 718, members of the Board are considered employees for calculation of stock-based compensation expense.
 
   
Three Months Ended
   
Nine Months Ended
 
   
December 31,
   
December 31,
 
   
2010
   
2009
   
2010
   
2009
 
Risk-free interest rate
    2.15 %     3.00 %     2.72 %     2.66 %
Expected life (in years)
    7.55       7.04       6.90       6.51  
Expected volatility
    86 %     87 %     84 %     87 %
Expected dividend yield
    --       --       --       --  
 
The following table summarizes stock options activity for the nine months ended December 31, 2010:
 
                     
Weighted
 
               
Weighted
   
Average
 
   
Number
   
Exercise
   
Average
   
Remaining
 
   
of Shares
   
Price Range
   
Exercise Price
   
Contractual Life
 
Outstanding at March 31, 2010
    6,264,685     $ 0.79 – $5.10     $ 1.91       5.84  
Granted
    687,500     $ 0.96 – $1.39       1.07          
Exercised
    (100,142 )   $ 1.10 – $1.34       1.12          
Canceled
    (180,464 )   $ 0.97 – $4.88       1.53          
Outstanding at December 31,  2010
    6,671,579     $ 0.79 – $5.10     $ 1.85       5.73  
Vested and expected to vest at December 31, 2010
    5,892,365     $ 0.79 – $5.10     $ 1.76       5.43  
Exercisable at December 31, 2010
    4,750,540     $ 0.79 – $5.10     $ 1.68       4.73  
 
At December 31, 2010, unrecognized stock-based compensation expense related to stock options was approximately $1.4 million and is expected to be recognized over a weighted average period of approximately 2.2 years.

The weighted average fair value of options granted during the three months ended December 31, 2010 and 2009 was $0.98 and $0.96 per share, respectively. The weighted average fair value of options granted during the nine months ended December 31, 2010 and 2009 was $0.82 and $0.91 per share, respectively.

The total intrinsic value (the excess of the market price over the exercise price) was approximately $1.1 million for stock options outstanding, $0.8 million for stock options exercisable, and $1.0 million for stock options vested and expected to vest as of December 31, 2010. The total intrinsic value for stock options exercised during the three months ended December 31, 2010 and 2009 was approximately $1 thousand. There were no stock options exercised during the three months ended September 30, 2009. The total intrinsic value for stock options exercised during the nine months ended December 31, 2010 and 2009 was approximately $22 thousand and $6 thousand, respectively.

We do not expect to realize any tax benefits from future disqualifying dispositions, if any, because we currently have a full valuation allowance against our deferred tax assets.
 
 
11

 

Stock Warrants

The following table summarizes stock warrants activity related to the Loan with the Lender for the nine months ended December 31, 2010:
 
         
Weighted
 
   
Number
   
Average
 
   
of Shares
   
Exercise Price
 
Nonvested at March 31, 2010
    189,394     $ 1.65  
Granted
    -        
Vested
    (189,394 )     1.65  
Forfeited
    -        
Nonvested at December 31, 2010
    -     $ 1.65  
Vested at December 31, 2010
    651,515     $ 1.53  
 
At December 31, 2010, unrecognized debt cost expense related to the Initial and Additional Warrant Shares was approximately $312 thousand, which is expected to be recognized over a weighted average period of approximately 1.9 years.

Restricted Stock

We granted 755,127 shares of restricted stock to management during the nine months ended December 31, 2010. The restrictions for these restricted stock awards lapse after certain Company (revenue and loss from operations) and individual milestones are met followed by a three-year graded vesting schedule. If the Company milestones are not met, regardless of whether the individual meets his or her performance milestones, the restricted stock awards are forfeited.

The following table summarizes restricted stock activity for the nine months ended December 31, 2010:

         
Weighted
 
   
Number
   
Average
 
   
of Shares
   
Grant Price
 
Nonvested at March 31, 2010
    -        
Granted
    755,127     $ 0.97  
Vested
    -        
Forfeited
    -        
Nonvested at December 31, 2010
    755,127     $ 0.97  
Vested at December 31, 2010
    -        
 
At December 31, 2010, unrecognized stock-based compensation expense related to nonvested awards was approximately $574 thousand, which is expected to be recognized over a weighted average period of approximately 3.2 years.

Note 8. Segment Information

We have two reportable segments, medical and industrial. Each of these operating segments has unique characteristics.

Our medical segment designs, manufactures and sells our advanced line of endoscopy-based products, including our state-of-the-art flexible endoscopes, and our Slide-On EndoSheath technology referred to as a sheath or EndoSheath disposable, for a variety of specialties and markets.

Our industrial segment, through our wholly-owned subsidiary Machida, designs, manufactures, and sells borescopes to a variety of users, primarily in the aircraft engine manufacturing and aircraft engine maintenance industries. A borescope is an instrument that uses optical fibers for the visual inspection of narrow cavities.  Our borescopes are used to inspect aircraft engines, casting parts and ground turbines, among other items.

Management evaluates the revenue and profitability performance of each of our product lines to make operating and strategic decisions. We have no intersegment revenue.
 
 
12

 

The following table presents key financial highlights, by reportable segments:

Three months ended December 31,
 
Medical
   
Industrial
   
Adjustments *
   
Consolidated
 
2010
                       
Net sales to external customers
  $ 2,068     $ 647     $ -     $ 2,715  
Gross profit
    620       189       -       809  
Operating loss
    (2,404 )     (41 )     -       (2,445 )
Interest expense, net
    (90 )     -       -       (90 )
Depreciation and amortization
    175       9       -       184  
Stock-based compensation expense
    357       21       -       378  
Total assets
    11,299       2,622       (2,284 )     11,637  
Expenditures for fixed assets
    159       -       -       159  
                                 
2009
                               
Net sales to external customers
  $ 1,842     $ 758     $ -     $ 2,600  
Gross profit
    8       342       -       350  
Operating (loss) income
    (3,324 )     96       -       (3,228 )
Interest income, net
    8       -       -       8  
Depreciation and amortization
    184       5       -       189  
Stock-based compensation expense
    239       22       -       261  
Total assets
    11,631       2,570       (2,362 )     11,839  
Expenditures for fixed assets
    162       8       -       170  
                                 
Nine months ended December 31,
                               
2010
                               
Net sales to external customers
  $ 5,909     $ 1,762     $ -     $ 7,671  
Gross profit
    1,589       550       -       2,139  
Operating loss
    (7,542 )     (175 )     -       (7,717 )
Interest expense, net
    (231 )     -       -       (231 )
Depreciation and amortization
    538       21       -       559  
Stock-based compensation expense
    1,231       79       -       1,310  
Expenditures for fixed assets
    220       -       -       220  
                                 
2009
                               
Net sales to external customers
  $ 6,695     $ 2,112     $ -     $ 8,807  
Gross profit
    552       1,051       -       1,603  
Operating (loss) income
    (9,194 )     347       -       (8,847 )
Interest income, net
    33       -       -       33  
Depreciation and amortization
    479       15       -       494  
Stock-based compensation expense
    1,085       92       -       1,177  
Expenditures for fixed assets
    593       8       -       601  
 
   
December 31,
 
* Adjustments
 
2010
   
2009
 
Intercompany eliminations
  $ (1,512 )   $ (1,397 )
Investment in subsidiaries
    (772 )     (965 )
Total adjustments
  $ (2,284 )   $ (2,362 )

 
13

 
 
Note 9. Advances from Customers

Exclusive Urology Supply Agreement with Stryker

On September 22, 2010, we signed a three-year agreement under which we will become the exclusive supplier to Stryker of Stryker-branded flexible video and fiber cystoscopes. These cystoscopes will employ our patented slide-on EndoSheath technology, which will be co-branded Stryker and Vision-Sciences. We will also supply Stryker with flexible ureteroscopes upon launch of this product line, expected to occur during calendar 2011. Stryker will initially have the exclusive rights to distribute products, including cystoscopes, urology EndoSheath technology, and ureteroscopes manufactured by us, in North and Latin America, South America, China and Japan and 12 months post-launch, throughout the rest of the world.

Subject to the terms of the Stryker Agreement, Stryker agreed to pay us a prepayment of $5 million, of which we received $2.5 million at signing and $2.5 million is due on or before March 31, 2011. The initial $2.5 million was recorded as an advance from customer in our condensed consolidated balance sheet. During the nine months ended December 31, 2010, we recognized $0.1 million in revenue for delivery of cystocopes and EndoSheath technology. We will continue to apply the amounts due from Stryker for purchases of scopes and EndoSheath technology to the prior advance by Stryker and recognize the associated revenue in accordance with our revenue recognition policy until the remaining $2.4 million is exhausted. Stryker will thereafter continue to pay us for products supplied. The purchase price for the products is based on our cost to manufacture plus a margin specified in the Stryker Agreement. We will recognize revenue for products sold to Stryker in a two-step process. The first step is recognition of revenue for our cost to manufacture these products when title passes to Stryker, generally upon shipment of our products F.O.B. shipping point. The second step is recognition of revenue for our specified margin of Stryker’s gross profit after Stryker sells the products to their end customers. There is no required minimum amount of scopes and EndoSheath products which Stryker is required to purchase from us. There can be no assurance that Stryker will purchase an amount of products in order for us to retain all or any portion of the prepayment or that we will not be required to refund all or a portion of the prepayments to Stryker.  If we are required to refund any amounts paid to us, it will have a material adverse effect on our financial condition.

SpineView Development and Supply Agreement

On June 19, 2008, we entered into a Development and Supply Agreement with SpineView, Inc. (the “SpineView Agreement”), pursuant to which we were to develop and supply a CCD-based video endoscope to SpineView for use with SpineView’s products. In September 2010, we received a prepayment of $1.4 million from SpineView for the initial, firm stocking order of 50 SpineView spinoscope sytems. We recorded this prepayment as an advance from customer in our condensed consolidated balance sheet. During the nine months ended December 31, 2010, we recognized $0.1 million in revenue for delivery of SpineView spinoscope systems. We will continue to apply the amounts due from SpineView to the prior advance by SpineView for purchases of scopes and recognize the associated revenue until the remaining $1.3 million is exhausted. SpineView will thereafter continue to pay us for products supplied.

Mr. Pell, our Chairman, is the Chairman of the SpineView board and an investor in SpineView. Messrs. Katsumi Oneda and John J. Rydzewski, members of our Board, are also investors in SpineView. Our policy with respect to transactions in which any of our directors or officers may have an interest, requires that such transaction (i) be on terms no less favorable to us than could be obtained from unaffiliated third parties and (ii) be approved by a majority of the uninterested, outside members of the Board.

At a Board meeting held on May 29, 2008, the Board reviewed the terms of the final draft of the SpineView Agreement, outside of the presence of Messrs. Pell and Oneda. The remaining (uninterested) members of our Board determined that the SpineView Agreement was fair, properly negotiated, and would be at least as favorable to us as could have been obtained from unaffiliated third parties, and accordingly, after discussion, it was approved. Mr. Rydzewski was neither an investor in SpineView nor a member of our Board at that time, and has no other relationship with SpineView.

Note 10. Subsequent Event

On January 18, 2011, we issued 7 million shares of our common stock at a purchase price of $1.50 per share to a number of investors in a private placement for aggregate proceeds of $10.5 million. We intend to use the proceeds from the private placement for working capital and general corporate purposes. We granted the investors in this private placement piggy-back registration rights, whereby if we decide to file a registration statement relating to an offering of any of our equity securities, other than on Form S-4 or Form S-8, then the investors will have the right, after notice, to include their securities in that registration statement. The investors in this private placement have no right to otherwise require us to register the sale of their shares.  
 
 
14

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

Forward Looking Statements

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of The Private Securities Litigation Reform Act of 1995, which are subject to various risks and uncertainties that could cause our actual results to differ materially from those expressed or implied in such statements. Such factors include, but are not limited to, further weakening of economic conditions that could adversely affect the level of demand for our products; our ability to satisfactorily distribute our ENT endoscopes without an arrangement with Medtronic; our ability to sell products to Stryker in at least the amounts necessary to retain the prepayments received from Stryker; pricing pressures, including cost-containment measures which could adversely affect the price of, or demand for, our products; availability of parts on acceptable terms; our ability to design new products and the success of such new products; changes in foreign exchange markets; changes in financial markets and changes in the competitive environment. 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. Generally, words such as “expect” “believe”, “anticipate”, “may”, “will”, “plan”, “intend”, “estimate”, “could”, and other similar expressions are intended to identify forward-looking statements. The forward-looking statements are based on our future plans, strategies, projections and predictions and 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 could include the availability of capital resources; the availability of third-party reimbursement; government regulation; the availability of raw material components; our ability to satisfactorily distribute our ENT endoscopes without an arrangement with Medtronic; our dependence on certain distributors and customers; our ability to affect expected sales to Stryker; competition; technological difficulties; general economic conditions and other risks detailed in this Quarterly Report on Form 10-Q and any subsequent periodic filings we make with the Securities and Exchange Commission (“SEC”). While we believe the assumptions underlying such forward-looking statements are reasonable, there can be no assurance that future events or developments will not cause such statements to be inaccurate. All forward-looking statements contained in this report are qualified in their entirety by this cautionary statement. We do not undertake an obligation to update our forward-looking statements to reflect future events or circumstances.

Registered Trademarks, Trademarks and Service Marks
 
Vision-Sciences, Inc. owns the registered trademarks Vision Sciences®, Slide-On®, EndoSheath®, and The Vision System®. Not all products referenced in this report are approved or cleared for sale, distribution, or use.

Executive Summary

We design, develop, manufacture, and market products for endoscopy – the science of using an instrument, known as an endoscope - to provide minimally invasive access to areas not readily visible to the human eye. We operate in two segments, medical and industrial. Our medical segment designs, manufactures, and sells our advanced line of endoscopy-based products, including our state-of-the-art flexible fiber and video endoscopes and our Slide-On EndoSheath technology, for a variety of specialties and markets. Our industrial segment, through our wholly-owned subsidiary, Machida, Inc. (“Machida”), designs, manufactures, and sells borescopes to a variety of users, primarily in the aircraft engine-manufacturing and aircraft engine-maintenance industries. A borescope is an instrument that uses optical fibers for the visual inspection of narrow cavities.

Medical Segment Areas

Within our medical segment we target four main areas for our fiber and video endoscopes and our EndoSheath technology: ENT (ear, nose, and throat), urology, gastroenterology (“GI”), and pulmonology. Within the ENT area, we manufacture ENT endoscopes and, for the past three fiscal years, had sold these scopes exclusively to Medtronic Xomed, Inc., the ENT subsidiary of Medtronic, Inc. (“Medtronic”) for use by ENT physicians. On February 11, 2010, we announced that Medtronic would no longer serve as the distributor for our ENT endoscopes effective April 1, 2010. Since April 1, 2010, we have sold our ENT endoscopes through our direct sales force in the U.S. and through distributors internationally. We manufacture our TNE (trans-nasal esophagoscopy) endoscopes and market them to ENT and GI physicians and bariatric surgeons. Within the urology area, we manufacture, market, and sell our cystoscopes and EndoSheath technology to urologists and other urology-gynecology related physicians. Pursuant to our agreement dated as of September 22, 2010, with the Endoscopy Division of Stryker Corporation (“Stryker”), we will supply to Stryker our flexible video and fiber cystoscopes and related EndoSheath products (the “Stryker Agreement”) (See Exclusive Urology Supply Agreement with Stryker section below for additional information). Within the GI area, we manufacture, market, and sell our TNE scopes and EndoSheath technology to GI physicians, primary care physicians, and others with a GI focus as part of their practice, in addition to bariatric surgeons. We manufacture, market, and sell our bronchoscope (an endoscope that allows detailed viewing of the lungs) and EndoSheath technology for bronchoscopy to pulmonologists, oncologists, thoracic surgeons, and other pulmonology-related physicians.
 
 
15

 

Value Proposition and Strategy
 
We believe our technology delivers significant value to our customers – doctors, clinics and hospitals – through reduced capital, staff and service costs, and increased patient throughput, practice revenue, and profitability. Our EndoSheath technology allows our customers to buy fewer endoscopes to service their patients and enables them to schedule more patient appointments in a single day. Our single-use EndoSheath technology provides a sterile barrier between patients and our reusable endoscopes, eliminating the need for time-consuming reprocessing routines necessary with conventional endoscopes. Our endoscopes are therefore typically ready for the next procedure in ten minutes, unlike conventional endoscopes which may take from 45 minutes to a day to reprocess. We believe our EndoSheath technology is the solution to the challenges and problems with conventional flexible endoscopes.  By offering a technology that provides simpler and quicker endoscope reprocessing and sterility derived from use of a single-use disposable sheath, we have removed the limitations of conventional flexible endoscopy.

Our current strategic focus is to transform ourselves from a research and development-focused company to a sales and marketing-driven Company, with the primary goal of increasing top-line revenue and margins.  We intend to do this by:

·  
Growing our direct sales force in the U.S. and enhancing our international distribution network;
·  
Expanding our downstream marketing efforts to end customers, including expanding our communications, advertising and branding;
·  
Increasing our clinical study activity in order to have peer-reviewed papers published which outline the benefits of our products;
·  
Targeting teaching hospitals and academic institutions as potential customers and reference and training centers;
·  
Leveraging our existing technology platform to explore new potential products and procedures in markets where we currently sell; and
·  
Exploring potential distribution arrangements with strategic partners.

New Product Releases
 
We continue to enhance our current family of videoscopes and improve and refine their manufacturing. With respect to our fiberscope line of products, in the first quarter of fiscal 2011, we launched our 4000 Series bronchoscope which is inserted down the mouth or nose into the lungs, providing visualization of the lungs and the ability to perform a variety of diagnostic and therapeutic procedures. In the first quarter of fiscal 2011, we launched our 2.8mm channel EndoSheath disposable for bronchoscopy to international pulmonology markets.

Exclusive Urology Supply Agreement with Stryker

On September 22, 2010, we signed a three-year agreement under which we will become the exclusive supplier to Stryker of Stryker-branded flexible video and fiber cystoscopes. These cystoscopes will employ our patented slide-on EndoSheath technology, which will be co-branded under the Stryker and Vision-Sciences names. We will also supply Stryker with flexible ureteroscopes upon launch of this product line, expected to occur during calendar 2011. Stryker will initially have the exclusive rights to distribute products, including cystoscopes, urology EndoSheath technology, and ureteroscopes manufactured by us, in North and Latin America, South America, China and Japan and 12 months post-launch, throughout the rest of the world.

Subject to the terms of the Stryker Agreement, Stryker agreed to pay us a prepayment of $5 million, of which we received $2.5 million at signing and $2.5 million is due on or before March 31, 2011. The initial $2.5 million was recorded as an advance from customer in our condensed consolidated balance sheet. During the nine months ended December 31, 2010, we recognized $0.1 million in revenue for delivery of cystocopes and EndoSheath technology to Stryker. We will continue to apply the amounts due from Stryker for purchases of scopes and EndoSheath technology to the prior advance made by Stryker and recognize the associated revenue in accordance with our revenue recognition policy until the remaining $2.4 million is exhausted. Stryker will thereafter continue to pay us for products supplied. The purchase price for the products will be based on our cost to manufacture plus a margin specified in the Stryker Agreement. We will recognize revenue for products sold to Stryker in a two-step process. The first step is recognition of revenue for our cost to manufacture these products when title passes to Stryker, generally upon shipment of our products F.O.B. shipping point. The second step is recognition of revenue for our specified margin of Stryker’s gross profit after Stryker sells the products to their end customers. There is no required minimum amount of scopes and EndoSheath products which Stryker is required to purchase from us. There can be no assurance that they will purchase an amount of products in order for us to retain all or any portion of the prepayment or that we will not be required to refund all or a portion of the prepayments to Stryker.  If we are required to refund any amounts paid to us, it will have a material adverse effect on our financial condition.

Line of Credit – Related Party

On November 9, 2009, we entered into a three-year $5.0 million revolving loan agreement (the “Loan”) with our Chairman, Lewis C. Pell (the “Lender”). Any amounts drawn against the Loan (an “Advance”) accrue interest at a per annum rate of 7.5%. The Lender received an availability fee equal to an annual rate of 0.5% on the unused portion of the Loan calculated based on the difference between the average annual principal amount of the outstanding Advances under the Loan and the maximum advance of $5.0 million. The availability of advances under the Loan is subject to customary conditions. As of December 31, 2010, we had fully drawn down the Loan. Subject to the terms of the Loan, we will be required to prepay all amounts outstanding under the Loan upon a change of control of the Company. We were required to prepay part or all of the amounts outstanding if we secured other financing or consummate a sale or license of assets, in each case resulting in net proceeds to us of $5.0 million or greater. In connection with our recent private placement (see Subsequent Event below for additional information), we received a waiver from the Lender such that we will not be required to repay all or any portion of the Advances with the proceeds from this fund raising.
 
 
16

 
 
In connection with the Loan, the Lender received  a five-year warrant (the “Initial Warrant Shares”) to purchase up to 272,727 shares of our common stock at an exercise price of $1.375 per share (representing 7.5% warrant coverage, or approximately 0.7% of our outstanding common stock), which immediately vested upon issuance. The second five-year warrant (the “Additional Warrant Shares”) to purchase up to an additional 378,788 shares of our common stock at an exercise price of $1.65 per share (representing up to an additional 12.5% warrant coverage, or approximately 1.0% of our outstanding common stock) vests at the time that each Advance is made in an amount equal to (i) the product of the amount of the Additional Warrant Shares multiplied by (ii) a ratio, (A) the numerator of which is the amount of the new Advance and (B) the denominator of which is $5.0 million. A portion of the Additional Warrant Shares vested on the date of the $2.5 million Advance on March 29, 2010, the $2.0 million Advance on June 29, 2010, and the $0.5 million Advance on December 16, 2010.

On the date of issuance, the fair value of the Initial and Additional Warrant Shares was approximately $221 thousand and $249 thousand, respectively. We defer costs associated with securing a line-of-credit or revolving loan agreement over the applicable term. These costs are amortized as debt cost expense in our condensed consolidated statement of operations.

At December 31, 2010, we had $5.0 million in outstanding borrowings under the Loan, which is reflected as line of credit – related party on our condensed consolidated balance sheet. The $5.0 million revolving loan expires in November 2012, at which time we must repay all borrowings under the Loan.

SpineView Development and Supply Agreement

On June 19, 2008, we entered into a Development and Supply Agreement with SpineView, Inc. (the “SpineView Agreement”), pursuant to which we were to develop and supply a CCD-based video endoscope to SpineView for use with SpineView’s products. In September 2010, we received a prepayment of $1.4 million from SpineView for the initial, firm stocking order of 50 SpineView spinoscope sytems. We recorded this prepayment as an advance from customer in our condensed consolidated balance sheet. During the nine months ended December 31, 2010, we recognized $0.1 million in revenue for delivery of SpineView spinoscope systems. We will continue to apply the payment to amounts due from SpineView for purchases of scopes and recognize the associated revenue until the remaining $1.3 million is exhausted. SpineView will thereafter continue to pay us for products supplied.

Mr. Pell, our Chairman, is the Chairman of the SpineView board and an investor in SpineView. Messrs. Katsumi Oneda and John J. Rydzewski, members of our Board, are also investors in SpineView. Our policy with respect to transactions in which any of our directors or officers may have an interest, requires that such transaction (i) be on terms no less favorable to us than could be obtained from unaffiliated third parties and (ii) be approved by a majority of the uninterested, outside members of the Board.

At a Board meeting held on May 29, 2008, the Board reviewed the terms of the final draft of the SpineView Agreement, outside of the presence of Messrs. Pell and Oneda. The remaining (uninterested) members of our Board determined that the SpineView Agreement was fair, properly negotiated, and would be at least as favorable to us as could have been obtained from unaffiliated third parties, and accordingly, after discussion, it was approved. Mr. Rydzewski was neither an investor in SpineView nor a member of our Board at that time, and has no other relationship with SpineView.

Subsequent Event

On January 18, 2011, we issued 7 million shares of our common stock at a purchase price of $1.50 per share to a number of investors in a private placement for aggregate proceeds of $10.5 million. We intend to use the proceeds from the private placement for working capital and general corporate purposes. We granted the investors in this private placement piggy-back registration rights, whereby if we decide to file a registration statement relating to an offering of any of our equity securities, other than on Form S-4 or Form S-8, then the investors will have the right, after notice, to include their securities in that registration statement. The investors in this private placement have no right to otherwise require us to register the sale of their shares.  
 
Results of Operations

Three months ended December 31, 2010 compared to the three months ended December 31, 2009 (in thousands, except percentages)

Net Sales

Net sales increased $0.1 million, or 4%, in the third quarter of fiscal 2011 to $2.7 million compared to $2.6 million in the third quarter of fiscal 2010. During the third quarter of fiscal 2011, our medical segment’s net sales of $2.1 million increased by $0.2 million, or 12%, primarily attributable to higher sales of our endoscopes and EndoSheath disposables in the urology market ($0.4 million). Our industrial segment’s net sales of $0.6 million decreased by $0.1 million, or 15%, primarily attributable to lower borescope sales ($0.2 million).
 
 
17

 

In the medical segment, we track sales of endoscopes and EndoSheath disposables by market. We also track sales of peripherals and accessories which can be sold to more than one market. Sales by segment, market, and by category for the three months ended December 31, 2010 and 2009 were as follows:

   
Three Months Ended
             
   
December 31,
             
Market/Category
 
2010
   
2009
   
Difference
   
Percentage
 
ENT and TNE
  $ 751     $ 550     $ 201       37 %
Urology
    827       444       383       86 %
Bronchoscopy
    70       94       (24 )     -26 %
SpineView
    -       225       (225 )     -100 %
Repairs, peripherals, and accessories
    420       529       (109 )     -21 %
Total medical sales
    2,068       1,842       226       12 %
Borescopes
    442       610       (168 )     -28 %
Repairs
    205       148       57       39 %
Total industrial sales
    647       758       (111 )     -15 %
Net sales
  $ 2,715     $ 2,600     $ 115       4 %

Medical Segment
 
Medical Segment – ENT and TNE Markets

 
Sales to the ENT and TNE markets include both our ENT and TNE endoscopes and EndoSheath disposables and were as follows:

   
Three Months Ended
December 31,
             
ENT/TNE Market
 
2010
   
2009
   
Difference
    Percentage  
Endoscopes
  $ 728     $ 541     $ 187       35 %
Slide-On EndoSheaths
    23       9       14       156 %
Total ENT/TNE market
  $ 751     $ 550     $ 201       37 %
 
Net sales to the ENT and TNE markets increased $0.2 million, or 37%, in the third quarter of fiscal 2011 to $0.8 million compared to $0.6 million in the third quarter of fiscal 2010. The increase in net sales was primarily attributable to higher sales of our videoscopes ($0.2 million).

Medical Segment – Urology Market

Sales to the urology market include urology endoscopes and EndoSheath disposables and were as follows:

   
Three Months Ended
December 31,
             
Urology Market
 
2010
   
2009
   
Difference
   
Percentage
 
Endoscopes
  $ 331     $ 163     $ 168       103 %
Slide-On EndoSheaths
    496       281       215       77 %
Total urology market
  $ 827     $ 444     $ 383       86 %
 
Net sales to the urology market increased $0.4 million, or 86%, in the third quarter of fiscal 2011 to $0.8 million compared to $0.4 million in the third quarter of fiscal 2010. The increase in net sales was primarily attributable to higher sales of our EndoSheath disposables ($0.2 million).
 
 
18

 

Medical Segment – Bronchoscopy Market

Sales to the bronchoscopy market include bronchoscopy endoscopes and EndoSheath disposables and were as follows:
 
   
Three Months Ended
December 31,
             
Bronchoscopy Market
 
2010
   
2009
   
Difference
   
Percentage
 
Endoscopes
  $ 37     $ 74     $ (37 )     -50 %
Slide-On EndoSheaths
    33       20       13       65 %
Total bronchoscopy market
  $ 70     $ 94     $ (24 )     -26 %
 
Net sales to the bronchoscopy market decreased $24 thousand, or 26%, in the third quarter of fiscal 2011 to $70 thousand compared to $94 thousand in the third quarter of fiscal 2010. The decrease in net sales was primarily attributable to lower sales of our videoscopes ($40 thousand).
 
Medical Segment – Repairs, Peripherals, and Accessories
 
Net sales of repairs, peripherals, and accessories decreased $0.1 million, or 21%, in the third quarter of fiscal 2011 to $0.4 million compared to $0.5 million in the third quarter of fiscal 2010. The decrease was primarily attributable to lower sales volume of peripherals and accessories for our ENT endoscopes due to the end of our distribution agreement with Medtronic ($0.1 million).
 
Industrial Segment
 
Net sales of industrial products of $0.6 million decreased $0.1 million, or 15%, in the third quarter of fiscal 2011 compared to $0.8 million in the third quarter of fiscal 2010. The decrease was primarily attributable to lower borescope sales ($0.2 million). This segment’s products are mature, and therefore, we expect future sales to remain relatively flat.
 
Gross Profit (Net Sales Less Cost of Sales)
 
Gross profit from our two reportable segments was as follows:
 
   
Three Months Ended
December 31,
             
Gross Profit
 
2010
   
2009
   
Difference
   
Percentage
 
Medical
  $ 620     $ 8     $ 612       7650 %
  As percentage of net sales
    30 %     0 %     30 %        
Industrial
    189       342       (153 )     -45 %
  As percentage of net sales
    29 %     45 %     -16 %        
Gross profit
  $ 809     $ 350     $ 459       131 %
Gross margin percentage
    30 %     13 %     17 %        
 
Gross profit increased $0.5 million, or 131%, in the third quarter of fiscal 2011 to $0.8 million from $0.4 million in the third quarter of fiscal 2010, primarily attributable to favorable manufacturing overhead absorption and a lower inventory reserve ($0.3 million). Gross margin percentage increased 17% in the third quarter of fiscal 2011 to 30% of net sales from 13% of net sales in the third quarter of fiscal 2010. The higher gross margin percentage was primarily attributable to favorable manufacturing overhead absorption and a lower inventory reserve in the third quarter of fiscal 2011 compared to the same period last year ($0.3 million, or 13% gross margin percentage impact).
 
 
19

 
 
Gross Profit – Medical Segment
 
Gross profit in our medical segment increased $0.6 million, or 7,650%, in the third quarter of fiscal 2011 to $0.6 million from $8 thousand in the third quarter of fiscal 2010, primarily attributable to favorable manufacturing overhead absorption and a lower inventory reserve ($0.6 million). Gross margin percentage increased 30% in the third quarter of fiscal 2011 to 30% of net sales from 0% of net sales in the third quarter of fiscal 2010. The higher gross margin percentage was primarily attributable to favorable manufacturing overhead absorption and a lower inventory reserve in the third quarter of fiscal 2011 compared to the same period last year ($0.6 million, or 28% gross margin percentage impact on our medical segment gross profit).
 
Gross Profit – Industrial Segment
 
Gross profit in our industrial segment decreased $0.2 million, or 45%, in the third quarter of fiscal 2011 to $0.2 million from $0.3 million in the third quarter of fiscal 2010, primarily attributable to unfavorable manufacturing overhead absorption ($0.2 million). Gross margin percentage decreased 16% in the third quarter of fiscal 2011 to 29% of net sales from 45% of net sales in the third quarter of fiscal 2010. The lower gross margin percentage was primarily attributable to unfavorable manufacturing overhead absorption, partially offset by a favorable materials usage variance ($0.1 million, or 20% gross margin percentage impact on our industrial segment gross profit).
 
Operating Expenses

Total operating expenses decreased $0.3 million, or 9%, in the third quarter of fiscal 2011 to $3.3 million from $3.6 million in the third quarter of fiscal 2010. Selling, general, and administrative (“SG&A”) expenses decreased $0.3 million, or 11%, and research and development (“R&D”) expenses decreased $4 thousand, or 1%, compared to the same period last year.

Operating expenses, by segment, were as follows:
 
   
Three Months Ended
December 31,
             
Operating Expenses
 
2010
   
2009
   
Difference
   
Percentage
 
SG&A expenses
                       
Medical
  $ 2,369     $ 2,673     $ (304 )     -11 %
Industrial
    230       246       (16 )     -7 %
Total SG&A expenses
    2,599       2,919       (320 )     -11 %
R&D expenses
                               
Medical
    655       659       (4 )     -1 %
Industrial
    -       -       -       -  
Total R&D expenses
    655       659       (4 )     -1 %
Total operating expenses
  $ 3,254     $ 3,578     $ (324 )     -9 %
 
SG&A Expenses – Medical Segment

SG&A expenses in our medical segment decreased $0.3 million, or 11%, in the third quarter of fiscal 2011 to $2.4 million, primarily attributable to one-time termination costs for the former Chief Executive Officer (“CEO”) recorded in the third quarter of fiscal 2010, which was not repeated in the current fiscal year ($0.5 million). Partially offsetting this decrease was higher stock-based compensation expense in the third quarter of fiscal 2011 compared to the same period last year ($0.2 million).
 
SG&A Expenses – Industrial Segment

SG&A expenses in our industrial segment decreased $16 thousand, or 7%, in the third quarter of fiscal 2011 to $230 thousand, primarily attributable to lower computer expenses ($7 thousand).

R&D Expenses – Medical Segment
 
R&D expenses in our medical segment decreased $4 thousand, or 1%, in the third quarter of fiscal 2011 to $0.7 million.

R&D Expenses – Industrial Segment
 
There were no material R&D expenses incurred by our industrial segment during the third quarter of fiscal 2011 or 2010.
 
 
20

 

Other (Expense) Income
 
Other (expense) income was as follows:
 
   
Three Months Ended
             
   
December 31,
             
Other (Expense) Income
 
2010
   
2009
   
Difference
   
Percentage
 
Interest income
  $ 1     $ 14     $ (13 )     -93 %
Interest expense
    (91 )     (6 )     (85 )     -1417 %
Debt cost expense
    (37 )     (12 )     (25 )     -208 %
Other expense
  $ (127 )   $ (4 )   $ (123 )     -3075 %
 
 Interest Income
 
Interest income decreased $13 thousand, or 93%, in the third quarter of fiscal 2011 primarily attributable to lower cash and short-term investments balances.
 
Interest Expense
 
Interest expense increased $85 thousand, or 1,417%, in the third quarter of fiscal 2011 primarily attributable to the interest associated with Advances of $5.0 million on the Loan.

Debt Cost Expense
 
Debt cost expense increased $25 thousand, or 208%, in the third quarter of fiscal 2011 primarily associated with the issuance of Additional Warrant Shares.

Net Loss
 
Net loss was as follows:
 
   
Three Months Ended
             
   
December 31,
             
Net Loss
 
2010
   
2009
   
Difference
   
Percentage
 
Loss before provision for income taxes
  $ (2,572 )   $ (3,232 )   $ (660 )     -20 %
Income tax provision
    4       2       2       100 %
Net loss
  $ (2,576 )   $ (3,234 )   $ (658 )     -20 %
 
Loss Before Provision for Income Taxes

Loss before provision for income taxes decreased $0.7 million, or 20%, in the third quarter of fiscal 2011 to $2.6 million, primarily attributable to a higher gross profit ($0.5 million).

Income Tax Provision

We recorded a provision for state income taxes of $4 thousand and $2 thousand in the third quarter of fiscal 2011 and 2010, respectively.

Net Loss

Net loss decreased $0.7 million, or 20%, in the third quarter of fiscal 2011 to $2.6 million, primarily attributable to a higher gross profit ($0.5 million).
 
 
21

 

Nine months ended December 31, 2010 compared to the nine months ended December 31, 2009 (in thousands, except percentages)

Net Sales

Net sales decreased $1.1 million, or 13%, in the first nine months of fiscal 2011 to $7.7 million compared to $8.8 million in the first nine months of fiscal 2010. During the first nine months of fiscal 2011, our medical segment’s net sales of $5.9 million decreased by $0.8 million, or 12%, primarily attributable to lower sales of our ENT fiberscopes due to the end of our distribution agreement with Medtronic ($0.8 million). Our industrial segment’s net sales of $1.8 million decreased by $0.4 million, or 17%, primarily attributable to lower sales of our borescopes ($0.4 million).

In the medical segment, we track sales of endoscopes and EndoSheath disposables by market. We also track sales of peripherals and accessories which can be sold to more than one market. Sales by segment, market, and by category for the nine months ended December 31, 2010 and 2009 were as follows:

   
Nine Months Ended
             
   
December 31,
             
Market/Category
 
2010
   
2009
   
Difference
   
Percentage
 
ENT and TNE
  $ 1,775     $ 2,744     $ (969 )     -35 %
Urology
    2,471       1,702       769       45 %
Bronchoscopy
    541       426       115       27 %
SpineView
    74       225       (151 )     -67 %
Repairs, peripherals, and accessories
    1,048       1,598       (550 )     -34 %
Total medical sales
    5,909       6,695       (786 )     -12 %
Borescopes
    1,223       1,581       (358 )     -23 %
Repairs
    539       531       8       2 %
Total industrial sales
    1,762       2,112       (350 )     -17 %
Net sales
  $ 7,671     $ 8,807     $ (1,136 )     -13 %

Medical Segment
 
Medical Segment – ENT and TNE Markets

Sales to the ENT and TNE markets include both our ENT and TNE endoscopes and EndoSheath disposables and were as follows:
 
   
Nine Months Ended
December 31,
             
ENT/TNE Market
 
2010
   
2009
   
Difference
    Percentage  
Endoscopes
  $ 1,733     $ 2,673     $ (940 )     -35 %
Slide-On EndoSheaths
    42       71       (29 )     -41 %
Total ENT/TNE market
  $ 1,775     $ 2,744     $ (969 )     -35 %
 
Net sales to the ENT and TNE markets decreased $1.0 million, or 35%, in the first nine months of fiscal 2011 to $1.8 million compared to $2.7 million in the first nine months of fiscal 2010. The decrease in net sales was primarily attributable to lower sales of our ENT fiberscopes due to the end of our distribution agreement with Medtronic ($0.8 million).
 
 
22

 

Medical Segment – Urology Market

Sales to the urology market include urology endoscopes and EndoSheath disposables and were as follows:

   
Nine Months Ended
December 31,
             
Urology Market
 
2010
   
2009
   
Difference
   
Percentage
 
Endoscopes
  $ 1,135     $ 711     $ 424       60 %
Slide-On EndoSheaths
    1,336       991       345       35 %
Total urology market
  $ 2,471     $ 1,702     $ 769       45 %
 
Net sales to the urology market increased $0.8 million, or 45%, in the first nine months of fiscal 2011 to $2.5 million compared to $1.7 million in the first nine months of fiscal 2010. The increase in net sales was primarily attributable to higher sales of our fiberscopes ($0.2 million) and EndoSheath disposables ($0.3 million).

Medical Segment – Bronchoscopy Market

Sales to the bronchoscopy market include bronchoscopy endoscopes and EndoSheath disposables and were as follows:

   
Nine Months Ended
December 31,
             
Bronchoscopy Market
 
2010
   
2009
   
Difference
   
Percentage
 
Endoscopes
  $ 475     $ 387     $ 88       23 %
Slide-On EndoSheaths
    66       39       27       69 %
Total bronchoscopy market
  $ 541     $ 426     $ 115       27 %
 
Net sales to the bronchoscopy market increased $0.1 million, or 27%, in the first nine months of fiscal 2011 to $0.5 million compared to $0.4 million in the first nine months of fiscal 2010. The increase in net sales was primarily attributable to higher sales of our fiberscopes ($0.1 million).

Medical Segment – Repairs, Peripherals, and Accessories
 
Net sales of repairs, peripherals, and accessories decreased $0.6 million, or 34%, in the first nine months of fiscal 2011 to $1.0 million compared to $1.6 million in the first nine months of fiscal 2010. The decrease was primarily attributable to lower sales volume of peripherals and accessories for our ENT endoscopes due to the end of our distribution agreement with Medtronic ($0.5 million).
 
Industrial Segment
 
Net sales of industrial products of $1.8 million decreased $0.4 million, or 17%, in the first nine months of fiscal 2011 compared to $2.1 million in the first nine months of fiscal 2010. The decrease was primarily attributable to lower sales of our borescopes ($0.4 million). This segment’s products are mature, and therefore, we expect future sales to remain relatively flat.
 
Gross Profit (Net Sales Less Cost of Sales)
 
Gross profit from our two reportable segments was as follows:
 
   
Nine Months Ended
December 31,
             
Gross Profit
 
2010
   
2009
   
Difference
   
Percentage
 
Medical
  $ 1,589     $ 552     $ 1,037       188 %
  As percentage of net sales
    27 %     8 %     19 %        
Industrial
    550       1,051       (501 )     -48 %
  As percentage of net sales
    31 %     50 %     -19 %        
Gross profit
  $ 2,139     $ 1,603     $ 536       33 %
Gross margin percentage
    28 %     18 %     10 %        
 
 
23

 
 
Gross profit increased $0.5 million, or 33%, in the first nine months of fiscal 2011 to $2.1 million from $1.6 million in the first nine months of fiscal 2010, primarily attributable to favorable manufacturing variances ($1.0 million), partially offset by loss in gross profit from lower sales volume (decrease in net sales of $1.1 million). Gross margin percentage increased 10% in the first nine months of fiscal 2011 to 28% of net sales from 18% of net sales in the first nine months of fiscal 2010. The higher gross margin percentage was primarily attributable to favorable manufacturing variances in the first nine months of fiscal 2011 compared to the same period last year ($1.0 million, or 13% gross margin percentage impact).

Gross Profit – Medical Segment
 
Gross profit in our medical segment increased $1.0 million, or 188%, in the first nine months of fiscal 2011 to $1.6 million from $0.6 million in the first nine months of fiscal 2010, primarily attributable to favorable manufacturing variances ($1.1 million). Gross margin percentage increased 19% in the first nine months of fiscal 2011 to 27% of net sales from 8% of net sales in the first nine months of fiscal 2010. The higher gross margin percentage was primarily attributable to favorable manufacturing variances in the first nine months of fiscal 2011 compared to the same period last year ($1.1 million, or 18% gross margin percentage impact on our medical segment gross profit).
 
Gross Profit – Industrial Segment
 
Gross profit in our industrial segment decreased $0.5 million, or 48%, in the first nine months of fiscal 2011 to $0.6 million from $1.1 million in the first nine months of fiscal 2010, primarily attributable to increased cost of sales for repairs and a higher inventory reserve ($0.3 million). Gross margin percentage decreased 19% in the first nine months of fiscal 2011 to 31% of net sales from 50% of net sales in the first nine months of fiscal 2010. The lower gross margin percentage was primarily attributable to increased cost of sales for repairs and a higher inventory reserve ($0.3 million, or 16% gross margin percentage impact on our industrial segment gross profit).
 
Operating Expenses

Total operating expenses decreased $0.6 million, or 6%, in the first nine months of fiscal 2011 to $9.9 million from $10.5 million in the first nine months of fiscal 2010. SG&A expenses decreased $0.2 million, or 3%, and R&D expenses decreased $0.4 million, or 15%, compared to the same period last year.

Operating expenses, by segment, were as follows:
 
   
Nine Months Ended
December 31,
             
Operating Expenses
 
2010
   
2009
   
Difference
   
Percentage
 
SG&A expenses
                       
Medical
  $ 7,147     $ 7,404     $ (257 )     -3 %
Industrial
    725       704       21       3 %
Total SG&A expenses
    7,872       8,108       (236 )     -3 %
R&D expenses
                               
Medical
    1,984