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EX-31.1 - EXHIBIT 31.1 - COGENTIX MEDICAL INC /DE/ex31-1.htm
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EX-31.2 - EXHIBIT 31.2 - COGENTIX MEDICAL INC /DE/ex31-2.htm
EX-32 - EXHIBIT 32 - COGENTIX MEDICAL INC /DE/ex32.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 September 30, 2011
 
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 October 31, 2011
 
Common Stock, par value of $0.01
44,662,426
(Title of Class)
(Number of Shares)



 
 

 

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
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
22
 
Item 4.
Controls and Procedures
22
       
Part II.
Other Information
 
 
Item 1.
Legal Proceedings
23
 
Item 1A.
Risk Factors
23
 
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
23
 
Item 3.
Defaults Upon Senior Securities
23
 
Item 4.
(Removed and Reserved)
24
 
Item 5.
Other Information
24
 
Item 6.
Exhibits
24
 
Signatures
25
 
 
2

 
 
PART I—FINANCIAL INFORMATION
Item 1: Financial Statements
 
Vision-Sciences, Inc. and Subsidiaries
Condensed Consolidated Balance Sheets
(In thousands, except per share amounts)
 
   
September 30,
   
March 31,
 
   
2011
   
2011
 
ASSETS
 
(unaudited)
       
Current assets:
           
Cash and cash equivalents
  $ 2,866     $ 9,180  
Accounts receivable, net of allowance for doubtful accounts of $73 and $56, respectively
    1,672       1,592  
Inventories, net
    6,307       6,096  
Prepaid expenses and other current assets
    376       332  
Total current assets
    11,221       17,200  
                 
Machinery and equipment
    3,422       3,182  
Demonstration equipment
    1,053       1,413  
Furniture and fixtures
    224       224  
Leasehold improvements
    372       372  
Total property and equipment, at cost
    5,071       5,191  
Less—accumulated depreciation and amortization
    2,799       2,970  
Total property and equipment, net
    2,272       2,221  
Other assets, net of accumulated amortization of $93 and $90, respectively
    70       73  
Deferred debt cost, net of accumulated amortization of $256 and $172, respectively
    1,804       272  
Total assets
  $ 15,367     $ 19,766  
                 
LIABILITIES AND STOCKHOLDERS' EQUITY
               
Current liabilities:
               
Capital lease obligations
  $ 97     $ 65  
Accounts payable
    748       921  
Accrued expenses
    537       782  
Accrued compensation
    761       706  
Advances from customers
    2,847       5,693  
Total current liabilities
    4,990       8,167  
Line of credit—related party
    6,000       5,000  
Capital lease obligations, net of current portion
    143       75  
Total liabilities
    11,133       13,242  
                 
Commitments and Contingencies
    -       -  
Stockholders’ equity:
               
Preferred stock, $0.01 par value—
               
Authorized—5,000 shares
               
Issued—none
    -       -  
Common stock, $0.01 par value—
               
Authorized—75,000 shares
               
Issued—44,663 shares and 44,025 shares, respectively
    447       440  
Additional paid-in capital
    97,632       94,339  
Treasury stock at cost, 3 shares and none, respectively
    (7 )     -  
Accumulated deficit
    (93,838 )     (88,255 )
Total stockholders’ equity
    4,234       6,524  
Total liabilities and stockholders’ equity
  $ 15,367     $ 19,766  

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
   
Six Months Ended
 
   
September 30,
   
September 30,
 
   
2011
   
2010
   
2011
   
2010
 
                         
Net sales
  $ 4,025     $ 2,325     $ 7,781     $ 4,957  
Cost of sales
    2,628       1,684       5,256       3,627  
Gross profit
    1,397       641       2,525       1,330  
                                 
Selling, general, and administrative expenses
    3,463       2,795       6,389       5,273  
Research and development expenses
    739       732       1,431       1,330  
Operating loss
    (2,805 )     (2,886 )     (5,295 )     (5,273 )
                                 
Interest income
    2       1       7       3  
Interest expense
    (99 )     (90 )     (198 )     (145 )
Debt cost expense
    (43 )     (36 )     (84 )     (63 )
Other, net
    (10 )     (1 )     (11 )     -  
Loss before provision for income taxes
    (2,955 )     (3,012 )     (5,581 )     (5,478 )
Income tax (benefit) provision
    (2 )     2       2       5  
Net loss
  $ (2,953 )   $ (3,014 )   $ (5,583 )   $ (5,483 )
                                 
Net loss per common share - basic and diluted
  $ (0.07 )   $ (0.08 )   $ (0.13 )   $ (0.15 )
                                 
Weighted average shares used in computing net loss per common share - basic and diluted
    44,204       36,901       44,116       36,879  

See accompanying notes to condensed consolidated financial statements.
 
 
4

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

   
Common Stock
   
Additional
   
Treasury Stock
         
Total
 
   
Number
    $0.01    
Paid-in
   
Number
         
Accumulated
   
Stockholders’
 
   
of Shares
   
Par Value
   
Capital
   
of Shares
   
Cost
   
Deficit
   
Equity
 
Balance at March 31, 2011
    44,025     $ 440     $ 94,339       -     $ -     $ (88,255 )   $ 6,524  
Exercise of stock options
    232       3       299       -       -       -       302  
Issuance of restricted stock awards
    406       4       -       -       -       -       4  
Issuance of stock warrants
    -       -       1,611       -       -       -       1,611  
Common stock repurchased
    -       -       -       3       (7 )     -       (7 )
Stock-based compensation expense
    -       -       1,383       -       -       -       1,383  
Net loss
    -       -       -       -       -       (5,583 )     (5,583 )
Balance at September 30, 2011
    44,663     $ 447     $ 97,632       3     $ (7 )   $ (93,838 )   $ 4,234  

See accompanying notes to condensed consolidated financial statements.
 
 
5

 
 
Vision-Sciences, Inc. and Subsidiaries
Condensed Consolidated Statements of Cash Flows
(In thousands)
(Unaudited)

   
Six Months Ended
 
   
September 30,
 
   
2011
   
2010
 
Cash flows from operating activities:
           
Net loss
  $ (5,583 )   $ (5,483 )
Adjustments to reconcile net loss to net cash used in operating activities:
               
Depreciation and amortization
    402       375  
Stock-based compensation expense
    1,383       932  
Issuance of restricted stock awards
    4       7  
Provision for (recovery of) bad debt expenses
    17       (180 )
Debt cost expense
    84       63  
Loss on disposal of fixed assets
    6       -  
Changes in assets and liabilities:
               
Accounts receivable
    (97 )     (264 )
Inventories
    (429 )     (909 )
Prepaid expenses and other current assets
    (44 )     664  
Accounts payable
    (173 )     791  
Accrued expenses
    (245 )     (271 )
Accrued compensation
    55       (22 )
Advances from customers
    (2,846 )     3,777  
Net cash used in operating activities
    (7,466 )     (520 )
Cash flows from investing activities:
               
Purchase of short-term investments
    -       (149 )
Proceeds from short-term investment sales/maturities
    -       596  
Proceeds from disposal of fixed assets
    3       -  
Purchase of property and equipment
    (106 )     (60 )
Net (cash used in) provided by investing activities
    (103 )     387  
Cash flows from financing activities:
               
Advance on line of credit—related party
    1,000       2,000  
Payments for deferred debt cost
    (5 )     -  
Payments of capital leases
    (35 )     (36 )
Proceeds from exercise of stock options
    302       109  
Common stock repurchased
    (7 )     -  
Net cash provided by financing activities
    1,255       2,073  
Net (decrease) increase in cash and cash equivalents
    (6,314 )     1,940  
Cash and cash equivalents at beginning of period
  $ 9,180     $ 2,540  
Cash and cash equivalents at end of period
  $ 2,866     $ 4,480  
                 
Supplemental disclosure of cash flow information:
               
Cash paid during the period for:
               
Interest
  $ 196     $ 56  
Income taxes
  $ 3     $ 23  
                 
Non-cash financing activities:
               
Issuance of stock warrants with line of credit—related party
  $ 1,611     $ 87  
Net transfers of inventory to fixed assets for use as demonstration equipment
  $ 218     $ 449  
Capital lease entered into for equipment purchase
  $ 135     $ -  

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 related notes included in our Annual Report on Form 10-K for the fiscal year ended March 31, 2011.

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 (“U.S.”) and independent distributors for the rest of the world. With respect to our urology products, we are the exclusive supplier to the Endoscopy Division of Stryker Corporation (“Stryker”). Our largest geographic markets are the U.S. and Europe.

We were incorporated in Delaware, and are the successor to operations originally begun in 1987. Machida Incorporated (“Machida”), our wholly-owned subsidiary, designs, manufactures, and sells borescopes to a variety of users, primarily in the aircraft engine manufacturing and aircraft engine maintenance industries.

We own the registered trademarks Vision Sciences®, Slide-On®, EndoSheath®, EndoWipe® 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 2012 and 2013. We have funded the losses principally with cash flow from operations, advances under a $10.0 million revolving loan agreement with our Chairman, Lewis C. Pell (the “Lender”), proceeds from equity financings (most recently the $10.5 million of proceeds we received from a private placement in January 2011), payments from Medtronic related to the sale of certain assets related to our ENT EndoSheath technology business, and the sale of other assets. We also received an aggregate of $6.4 million of deposits from two customers (the “Prepayments”) during fiscal 2011 to support anticipated sales orders, some of which have shipped through the second quarter of fiscal 2012 and the remainder are expected to ship over the course of the next few quarters. We have invested some of our working capital in inventory to fulfill these orders and forecasts provided from Stryker. We believe that our cash and the $4.0 million of capital available, subject to certain conditions, under the revolving loan agreement at September 30, 2011 will be sufficient to fund our working capital needs, capital expenditures, and future operating losses through September 30, 2012. However, if our performance expectations fall short (including 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. If required, we believe we would be able to reduce our expenses to a sufficient level.
 
 
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 Adopted

In January 2010, the Financial Accounting Standard Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2010-06 (“ASC Update 2010-06”), an update to ASC 820 (Topic 820, Fair Value Measurement). 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 became effective for us with the reporting period beginning April 1, 2011 (our fiscal year 2012). The adoption of the provisions of the update effective April 1, 2011 did not have a material effect on our results of operations, financial position, or liquidity.

Note 3.                      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 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:
 
   
September 30,
   
March 31,
 
   
2011
   
2011
 
Raw materials
  $ 4,948     $ 4,967  
Work in process
    432       324  
Finished goods
    927       805  
Inventories, net
  $ 6,307     $ 6,096  

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.                      Advances from Customers

Exclusive Urology Supply Agreement with Stryker

On September 22, 2010, we signed a three-year agreement (the “Stryker Agreement”) under which we became 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 fiscal 2012. Stryker will initially have the exclusive rights to distribute our cystoscopes, urology EndoSheath technology, and ureteroscopes, in North and Latin America, South America, China and Japan and 12 months post-launch, throughout the rest of the world. Stryker launched these product lines during April 2011 and introduced them at the American Urological Association annual meeting in May 2011.
 
 
8

 

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, based upon reports received from Stryker monthly. While growing each month, such amounts have not been significant to date. There is no required minimum amount of scopes and EndoSheath products which Stryker is required to purchase from us.

During fiscal 2011, we received a prepayment from Stryker of $5 million, of which we received $2.5 million at signing and the balance in March 2011. The prepayment was recorded as an advance from customer in our condensed consolidated balance sheet. During the three and six months ended September 30, 2011, we recognized $0.9 million and $2.5 million in revenue, respectively, for delivery of cystocopes and EndoSheath technology. At September 30, 2011, the advance from customer balance pertaining to Stryker was $2.0 million. 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. Stryker will thereafter continue to pay us for products supplied.

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 surgical 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 surgical endoscope systems. We recorded this prepayment as an advance from customer in our condensed consolidated balance sheet. During the six months ended September 30, 2011, we recognized $0.4 million in revenue for delivery of SpineView surgical endoscope systems. At September 30, 2011, the advance from customer balance pertaining to SpineView was $0.8 million. 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 balance is exhausted. SpineView will thereafter continue to pay us for products supplied.
 
Note 6.                      Line of Credit – Related Party

On September 30, 2011 (the “Effective Date”), we entered into an Amended and Restated Revolving Loan Agreement (the “Agreement”) with the Lender providing for an additional $5.0 million in available loans (the “New Loan”) to us, in addition to $5.0 million previously borrowed under the Original Agreement (as defined below), for an aggregate loan of up to $10.0 million.

This Agreement amends and restates the original Revolving Loan Agreement between the Lender and us dated November 9, 2009 (the “Original Agreement”) pursuant to which we borrowed $5 million (the “Original Loan Amount”). Under the Agreement, we may draw up to the New Loan Amount until the third anniversary of the Effective Date or such earlier time as the agreement is terminated in accordance with its terms. The Agreement extends the Original Loan Amount repayment date to be consistent with the New Loan Amount and extends the expiration date of the stock warrants issued under the Original Loan Agreement to be consistent with the terms of the New Warrant (as defined below).

Subject to the terms of the Agreement, we will be required to prepay all amounts outstanding under the Agreement upon a change in control or event of default. In addition, we will be required to repay all of the New Loan and a portion of the Original Loan Amount, if we secure other financing or consummate a sale or license of assets.
 
Any amounts drawn against the New Loan (an “Advance”) accrue interest at an annual rate of 7.5%. The Lender will receive an availability fee equal to an annual rate of 0.5% on the unused portion of the New Loan calculated based on the difference between the average annual principal amount of the outstanding Advances under the Agreement and the maximum amount of aggregate Advances of $10.0 million.

In connection with the Loan Agreement, the Lender received a warrant to purchase an aggregate of 1,229,105 shares of our common stock at an exercise price of $2.034 per share (the “New Warrant”).  The New Warrant vested immediately upon issuance and expires on the later of the fifth anniversary of the Effective Date or one year after the termination of the Loan Agreement (the "Expiration Date") and repayment of all amounts due and payable under the Loan Agreement.
 
We have accounted for the fair value of the New Warrant and incremental fair value arising from the extension of the maturity date of the old warrants as an increase to the deferred debt cost. Such deferred debt costs are amortized to expense over the term of the Loan Agreement to its Expiration Date.
 
 
9

 

We estimated the fair value of all of the stock warrants issued on the date of vesting using a Black-Scholes valuation model that used the weighted average assumptions for the risk-free interest rate, expected life (in years), and expected volatility. The following table summarizes Advances taken and warrant issuances:
 
Month
 
Amount of
Advance
   
Number of
Warrant Shares
Vested
 
Fair Value of
Warrant Shares
on Date Vested
September 2011
 
$1.0 million
    1,229,105  
$1.5 million
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
                   
Total
 
$6.0 million
      1,880,620  
$2.0 million
 
At September 30, 2011, we had $6.0 million in outstanding borrowings under the Loan, which is reflected as line of credit – related party on our condensed consolidated balance sheet. The $10.0 million revolving loan expires in November 2014, at which time we must repay all outstanding borrowings under the Agreement.

Debt cost expense and interest expense related to the stock warrants and availability fee and accrued interest on outstanding borrowings, respectively, for the three and six months ended September 30, 2011 and 2010 was recorded in our condensed consolidated statement of operations as follows:
 
   
Three Months Ended
   
Six Months Ended
 
   
September 30,
   
September 30,
 
   
2011
   
2010
   
2011
   
2010
 
Debt cost expense
  $ 43     $ 36     $ 84     $ 63  
Interest expense
    96       87       191       138  
 
At September 30, 2011, we had $0.1 million in accrued interest related to the Agreement, which is included in accounts payable 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 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.
 
 
10

 

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. Under the provisions of ASC 718, members of the Board are considered employees for calculation of stock-based compensation expense.

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.
 
   
Three Months Ended
   
Six Months Ended
 
   
September 30,
   
September 30,
 
   
2011
   
2010
   
2011
   
2010
 
Risk-free interest rate
    1.17%       2.30%       1.44%       2.77%  
Expected life (in years)
    5.5       7.2       6.0       6.8  
Expected volatility
    88%       86%       87%       86%  
Expected dividend yield
    --       --       --       --  

Stock-based compensation expense for the three and six months ended September 30, 2011 and 2010 was recorded in our condensed consolidated statement of operations as follows:
 
   
Three Months Ended
   
Six Months Ended
 
   
September 30,
   
September 30,
 
   
2011
   
2010
   
2011
   
2010
 
Cost of sales
  $ 41     $ 61     $ 81     $ 137  
Selling, general, and administrative expenses
    855       460       1,273       746  
Research and development expenses
    13       19       29       49  
Total stock-based compensation expense
  $ 909     $ 540     $ 1,383     $ 932  

At September 30, 2011, unrecognized stock-based compensation expense related to stock options was approximately $2.3 million and is expected to be recognized over a weighted average period of approximately 2.7 years.

The following table summarizes stock options activity for the six months ended September 30, 2011:
 
                     
Weighted
 
               
Weighted
   
Average
 
   
Number
   
Exercise
   
Average
   
Remaining
 
   
of Shares
   
Price Range
   
Exercise Price
   
Contractual Life
 
Outstanding at March 31, 2011
    6,558,701       $0.79 – $5.10       $1.91       5.3  
Granted
    1,302,950       $2.22 – $2.78       2.36          
Exercised
    (232,009)       $0.85 – $2.05       1.30          
Canceled
    (80,625)       $0.85 – $5.10       3.17          
Outstanding at September 30,  2011
    7,549,017       $0.79 – $4.88       $1.94       5.7  
Vested and expected to vest at September 30, 2011
    7,069,417       $0.79 – $4.88       $1.90       5.5  
Exercisable at September 30, 2011
    5,482,567       $0.79 – $4.88       $1.82       4.5  
 
 
During the three months ended September 30, 2011, in connection with the appointment of Cynthia Ansari as our Chief Executive Officer, we granted her 750,000 options to purchase our common stock at a price of $2.22 per share.  These options vest as follows: 25% (187,500) upon her start date (August 11, 2011) and 25% on each of the first, second, and third year anniversaries of her start date. Ms. Ansari will also be granted an additional 750,000 stock options on the first year anniversary of her start date, with this grant vesting over four years, with 25% vesting on each of the first, second, third, and fourth anniversaries of the grant.
 
The weighted average fair value of options granted during the three months ended September 30, 2011 and 2010 was $1.60 and $0.87 per share, respectively. The weighted average fair value of options granted during the six months ended September 30, 2011 and 2010 was $1.70 and $0.79 per share, respectively.
 
 
11

 

The total intrinsic value (the excess of the market price over the exercise price) was approximately $3.2 million for stock options outstanding, $2.7 million for stock options exercisable, and $3.0 million for stock options vested and expected to vest as of September 30, 2011. The total intrinsic value for stock options exercised during the three months ended September 30, 2011 and 2010 was approximately $77 thousand and $21 thousand, respectively. The total intrinsic value for stock options exercised during the six months ended September 30, 2011 and 2010 was approximately $281 thousand and $21 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.

Stock Warrants

We had 1,880,620 stock warrants outstanding with a weighted average exercise price of $1.86 at September 30, 2011. At September 30, 2011, unrecognized debt cost expense related to the stock warrants was approximately $1.8 million, which is expected to be recognized over a weighted average period of approximately 3.1 years.

Restricted Stock

During the six months ended September 30, 2011, we granted 366,089 shares and 40,000 shares of restricted stock to management and outside directors of our Board, respectively, under our 2007 Plan. At the time of her appointment, Ms. Ansari was granted 118,244 shares of restricted stock, which is included in the number granted to management during the period.  The restrictions on 59,122 shares of restricted stock lapse in quarterly installments starting on each of June 30, 2012, September 30, 2012, December 31, 2012, and March 31, 2013.  The restrictions on the remainder will lapse consistent with the shares of restricted stock granted to the other management employees. Those restrictions for the restricted stock awards granted to management lapse after certain Company (net sales and operating loss) and individual milestones are met followed by a three-year graded vesting schedule. Irrespective of achieving the Company milestones, management will receive 25% of their restricted stock award if their individual milestones are met. The restrictions for the restricted stock awards granted to outside directors lapse quarterly over a one-year period.

The following table summarizes restricted stock activity for the six months ended September 30, 2011:
 
         
Weighted
 
   
Number
   
Average
 
   
of Shares
   
Grant Price
 
Nonvested at March 31, 2011
    40,000     $ 2.00  
Granted
    406,089       2.53  
Vested
    (20,000 )     2.00  
Forfeited
    -        
Nonvested at September 30, 2011
    426,089     $ 2.51  

We determined stock-based compensation expense for performance based restricted stock based upon the fair value of our common stock at the date of grant and recognized expense based upon the most probable outcome as to whether the performance targets will be achieved and the stock-based compensation being earned.

During the six months ended September 30, 2011, we recognized approximately $134 thousand of stock-based compensation expense related to performance based restricted stock awards. At September 30, 2011, unrecognized stock-based compensation expense related to nonvested awards was approximately $850 thousand, which is expected to be recognized over a weighted average period of approximately 2.9 years.

Note 8.                      Treasury Stock

We repurchased 3,268 shares of our common stock at its fair value for a cost of $7 thousand during the six months ended September 30, 2011. The shares were purchased from a management employee to cover income tax withholdings upon the lapse of restrictions on a restricted stock award. Although not required to under our equity incentive plans, we anticipate repurchasing shares in a similar arrangement during the remainder of fiscal 2012.

Note 9.                      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.
 
 
12

 

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

The following table presents key financial highlights, by reportable segments:
 
Three months ended September 30,
 
Medical
   
Industrial
   
Adjustments *
   
Consolidated
 
2011
                       
Net sales
  $ 3,384     $ 641     $ -     $ 4,025  
Gross profit
    1,143       254       -       1,397  
Operating loss
    (2,739 )     (66 )     -       (2,805 )
Interest expense, net
    (97 )     -       -       (97 )
Depreciation and amortization
    201       12       -       213  
Stock-based compensation expense
    890       19       -       909  
Total assets
    15,901       1,329       (1,863 )     15,367  
Expenditures for fixed assets
    30       -       -       30  
                                 
2010
                               
Net sales
  $ 1,721     $ 604     $ -     $ 2,325  
Gross profit
    447       194       -       641  
Operating loss
    (2,838 )     (48 )     -       (2,886 )
Interest expense, net
    (89 )     -       -       (89 )
Depreciation and amortization
    179       7       -       186  
Stock-based compensation expense
    522       18       -       540  
Total assets
    13,124       2,253       (1,987 )     13,390  
Expenditures for fixed assets
    50       -       -       50  
                                 
Six months ended September 30,
                               
2011
                               
Net sales
  $ 6,489     $ 1,292     $ -     $ 7,781  
Gross profit
    2,043       482       -       2,525  
Operating loss
    (5,100 )     (195 )     -       (5,295 )
Interest expense, net
    (191 )     -       -       (191 )
Depreciation and amortization
    379       23       -       402  
Stock-based compensation expense
    1,323       60       -       1,383  
Expenditures for fixed assets
    106       -       -       106  
                                 
2010
                               
Net sales
  $ 3,840     $ 1,117     $ -     $ 4,957  
Gross profit
    969       361       -       1,330  
Operating loss
    (5,138 )     (135 )     -       (5,273 )
Interest expense, net
    (142 )     -       -       (142 )
Depreciation and amortization
    364       11       -       375  
Stock-based compensation expense
    874       58       -       932  
Expenditures for fixed assets
    60       -       -       60  
                                 
   
September 30,
                 
* Adjustments
    2011       2010                  
  Intercompany eliminations
  $ (1,177 )   $ (1,215 )                
  Investment in subsidiaries
    (686 )     (772 )                
  Total adjustments
  $ (1,863 )   $ (1,987 )                
 
 
13

 

The following table presents the reconciliation to loss before provision for income taxes for the three and six months ended September 30, 2011 and 2010:
 
   
Three Months Ended
   
Six Months Ended
 
   
September 30,
   
September 30,
 
Reconciliation to loss before provision for income taxes:
 
2011
   
2010
   
2011
   
2010
 
Operating loss
  $ (2,805 )   $ (2,886 )   $ (5,295 )   $ (5,273 )
Interest expense, net
    (97 )     (89 )     (191 )     (142 )
Debt cost expense
    (43 )     (36 )     (84 )     (63 )
Other, net
    (10 )     (1 )     (11 )     -  
Loss before provision for income taxes
  $ (2,955 )   $ (3,012 )   $ (5,581 )   $ (5,478 )
 
Note 10.                      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 9,833,226 shares and 8,072,989 shares as of September 30, 2011 and 2010, respectively, were excluded from the calculation of fully diluted loss per share as their inclusion would have been anti-dilutive due to our net loss per share.
 
 
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 remainder of the prepayments received from Stryker; Stryker's ability to successfully market and sell the products we manufacture for them; 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 effect expected sales to Stryker (and the expected margin of such sales); 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®, EndoWipe® 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 five main areas for our fiber and video endoscopes and our EndoSheath technology:

 
·
ENT (ear, nose, and throat) – we manufacture ENT endoscopes for use by ENT physicians. We manufacture our TNE (trans-nasal esophagoscopy) endoscopes and also market and sell them to ENT physicians.
 
·
Urology – 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 supply to Stryker our flexible video and fiber cystoscopes and related EndoSheath products (the “Stryker Agreement”) (See Exclusive Urology Supply Agreement with Stryker below for additional information).
 
·
Gastroenterology (“GI”) – 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.
 
·
Pulmonology – 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.
 
·
Spine – pursuant to our agreement dated as of June 19, 2008, with SpineView, Inc. (“SpineView”), we supply to SpineView our flexible video surgical endoscope systems for use with SpineView’s products (See SpineView Development and Supply Agreement below for additional information).

We sell our ENT and TNE endoscopes and bronchoscopes through our direct sales force in the U.S. For the rest of the world, we sell our ENT and TNE endoscopes, bronchoscopes, and cystoscopes through international distributors.
 
 
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 or more 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 continue 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 are doing this by:

 
·
Growing our direct sales force in the U.S. and enhancing our international distribution network;
 
·
Expanding our supply agreements;
 
·
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 Development and Release
 
We continue to enhance our current family of videoscopes and improve and refine the manufacturing process. With respect to our fiberscope line of products, during 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. Additionally, during fiscal 2011, we launched our 2.8mm channel EndoSheath disposable for bronchoscopy to international pulmonology markets and we expect to launch this same product in the U.S. during the first half of fiscal 2013.

We are working on a CCD-based flexible ureteroscope, an endoscope for visually examining and passing instruments into the interior of the urethra (the tube that carries urine from the bladder to outside of the body). This revolutionary 7000 Series ureteroscope, which we plan to launch in fiscal 2012, will be the smallest video ureteroscope released. In addition, in fiscal 2012, we plan to release our new generation 7000 Series video processor. In the second quarter of fiscal 2012, we released our second generation 5000 Series video processor. Both of these will augment our 5000 Series processor product line. These next generation processors will contain more features, while retaining the same compact size of our current models. Finally, we are also examining market and product potential for a trans-nasal gastroscope (TEGD scope).

While we currently anticipate the development and release of the products as noted above, there can be no assurances that the timelines and related budgeted costs will be attained.

Line of Credit – Related Party

On September 30, 2011 (the “Effective Date”), we entered into an Amended and Restated Revolving Loan Agreement (the “Agreement”) with our Chairman, Lewis C. Pell (the “Lender”) providing for an additional $5.0 million in available loans (the “New Loan”) to us, in addition to $5.0 million previously borrowed under the Original Agreement (as defined below), for an aggregate loan of up to $10.0 million.

This Agreement amends and restates the original Revolving Loan Agreement between the Lender and us dated November 9, 2009 (the “Original Agreement”) pursuant to which we borrowed $5 million (the “Original Loan Amount”). Under the Agreement, we may draw up to the New Loan Amount until the third anniversary of the Effective Date or such earlier time as the agreement is terminated in accordance with its terms. The Agreement extends the Original Loan Amount repayment date to be consistent with the New Loan Amount and extends the expiration date of the stock warrants issued under the Original Loan Agreement to be consistent with the terms of the New Warrant (as defined below).

Subject to the terms of the Agreement, we will be required to prepay all amounts outstanding under the Agreement upon a change in control or event of default. In addition, we will be required to repay all of the New Loan and a portion of the Original Loan Amount, if we secure other financing or consummate a sale or license of assets.
 
Any amounts drawn against the New Loan (an “Advance”) accrue interest at an annual rate of 7.5%. The Lender will receive an availability fee equal to an annual rate of 0.5% on the unused portion of the New Loan calculated based on the difference between the average annual principal amount of the outstanding Advances under the Agreement and the maximum amount of aggregate Advances of $10.0 million.

In connection with the Loan Agreement, the Lender received a warrant to purchase an aggregate of 1,229,105 shares of our common stock at an exercise price of $2.034 per share (the “New Warrant”).  The New Warrant vested immediately upon issuance and expires on the later of the fifth anniversary of the New Warrant or one year after the termination of the Loan Agreement (the “Expiration Date”) and repayment of all amounts due and payable thereunder.
 
 
16

 
 
At September 30, 2011, we had $6.0 million in outstanding borrowings under the Loan, which is reflected as line of credit – related party on our condensed consolidated balance sheet. The $10.0 million revolving loan expires in November 2014, at which time we must repay all outstanding borrowings under the Agreement.

Exclusive Urology Supply Agreement with Stryker

On September 22, 2010, we signed a three-year agreement under which we became 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 fiscal 2012. 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. Stryker launched these product lines during April 2011 and introduced them at the American Urological Association annual meeting in May 2011.

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, based upon reports received from Stryker monthly. While growing each month, such amounts have not been significant to date. There is no cost of sales associated with revenue under this second step. There is no required minimum amount of scopes and EndoSheath products which Stryker is required to purchase from us.

During fiscal 2011, we received a prepayment from Stryker of $5 million, of which we received $2.5 million at signing and the balance in March 2011. The prepayment was recorded as an advance from customer in our condensed consolidated balance sheet. During the six months ended September 30, 2011, we recognized $2.5 million in revenue for delivery of cystocopes and EndoSheath technology. At September 30, 2011, the advance from customer balance pertaining to Stryker was $2.0 million. 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. Stryker will thereafter continue to pay us for products supplied.

SpineView Development and Supply Agreement

On June 19, 2008, we entered into a Development and Supply Agreement with SpineView (the “SpineView Agreement”), pursuant to which we were to develop and supply a CCD-based video surgical 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 surgical endoscope systems. We recorded this prepayment as an advance from customer in our condensed consolidated balance sheet. During the six months ended September 30, 2011, we recognized $0.4 million in revenue for delivery of SpineView surgical endoscope systems. At September 30, 2011, the advance from customer balance pertaining to SpineView was $0.8 million. 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 balance is exhausted. SpineView will thereafter continue to pay us for products supplied.
 
 
17

 

Results of Operations (in thousands, except percentages)

Net Sales

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. Net sales by operating segment and by market/category for the three and six months ended September 30, 2011 and 2010 were as follows:
 
   
Three Months Ended
         
Six Months Ended
       
   
September 30,
         
September 30,
       
Market/Category
 
2011
   
2010
   
Change
   
2011
   
2010
   
Change
 
ENT and TNE
  $ 878     $ 590       49 %   $ 1,355     $ 1,024       32 %
Urology
    1,503       699       115 %     3,412       1,644       108 %
Bronchoscopy
    203       54       276 %     310       471       -34 %
Spine
    348       74       370 %     426       74       476 %
Repairs, peripherals, and accessories
    452       304       49 %     986       627       57 %
Total medical sales
    3,384       1,721       97 %     6,489       3,840       69 %
Borescopes
    451       416       8 %     959       782       23 %
Repairs
    190       188       1 %     333       335       -1 %
Total industrial sales
    641       604       6 %     1,292       1,117       16 %
Net sales
  $ 4,025     $ 2,325       73 %   $ 7,781     $ 4,957       57 %

Net sales increased $1.7 million, or 73%, in the second quarter of fiscal 2012 to $4.0 million compared to $2.3 million in the second quarter of fiscal 2011. During the second quarter of fiscal 2012, our medical segment’s net sales of $3.4 million increased by $1.7 million, or 97%, attributable to higher sales in all of our markets in which we serve. Our industrial segment’s net sales of $0.6 million increased by $37 thousand, or 6%, primarily attributable to higher borescope sales. This operating segment’s products are mature, and therefore, we expect future sales to remain relatively flat.

Net sales increased $2.8 million, or 57%, in the first half of fiscal 2012 to $7.8 million compared to $5.0 million in the first half of fiscal 2011. During the first half of fiscal 2012, our medical segment’s net sales of $6.5 million increased by $2.6 million, or 69%, primarily attributable to higher sales of our endoscopes and EndoSheath disposables in the urology market as a result of the Stryker Agreement. Our industrial segment’s net sales of $1.3 million increased by $0.2 million, or 16%, primarily attributable to higher borescope sales.
 
 
18

 

The following table summarizes net sales by market/category and by product for our medical operating segment for the three and six months ended September 30, 2011 and 2010:
 
   
Three Months Ended
         
Six Months Ended
       
   
September 30,
         
September 30,
       
Market/Category
 
2011
   
2010
   
Change
   
2011
   
2010
   
Change
 
ENT and TNE
                                   
Endoscopes
  $ 850     $ 583       46 %   $ 1,312     $ 1,005       31 %
Slide-On EndoSheaths
    28       7       300 %     43       19       126 %
Total ENT/TNE market
    878       590       49 %     1,355       1,024       32 %
                                                 
Urology
                                               
Endoscopes
    860       322       167 %     2,022       804       151 %
Slide-On EndoSheaths
    643       377       71 %     1,390       840       65 %
Total urology market
    1,503       699       115 %     3,412       1,644       108 %
                                                 
Bronchoscopy
                                               
Endoscopes
    178       44       305 %     259       438       -41 %
Slide-On EndoSheaths
    25       10       150 %     51       33       55 %
Total bronchoscopy market
    203       54       276 %     310       471       -34 %
                                                 
Spine
                                               
Endoscopes
    348       74       370 %     426       74       476 %
                                                 
Repairs, peripherals, and accessories
    452       304       49 %     986       627       57 %
Total medical sales
  $ 3,384     $ 1,721       97 %   $ 6,489     $ 3,840       69 %
                                                 
Product
                                               
Endoscopes
  $ 2,236     $ 1,023       119 %   $ 4,019     $ 2,321       73 %
Slide-On EndoSheaths
    696       394       77 %     1,484       892       66 %
Repairs, peripherals, and accessories
    452       304       49 %     986       627       57 %
Total medical sales
  $ 3,384     $ 1,721       97 %   $ 6,489     $ 3,840       69 %
 
Net sales to the ENT and TNE markets were $0.9 million and $1.4 million in the second quarter and first half of fiscal 2012, respectively, representing increases of $0.3 million (49%) and $0.3 million (32%) over the same periods in fiscal 2011. Continued expansion in the GI and bariatric surgery markets and growth in our customer base in the ENT market contributed to the year-over-year growth.

Net sales to the urology market were $1.5 million and $3.4 million in the second quarter and first half of fiscal 2012, respectively, representing increases of $0.8 million (115%) and $1.8 million (108%) over the same periods in fiscal 2011. The year-over-year growth was primarily attributable to the expanded U.S. distribution of our flexible video and fiber cystoscopes and related EndoSheath products to Stryker after their launch of these products in April 2011.

Net sales to the bronchoscopy market were $0.2 million and $0.3 million in the second quarter and first half of fiscal 2012, respectively, representing an increase of $0.1 million (276%) over the second quarter of fiscal 2011 and a decrease of $0.2 million (-34%) compared to the first half of fiscal 2011. The prior year net sales benefited from stocking orders of our videoscopes from our international distributors, which was not repeated in the current fiscal year. We continue to enhance and expand our international distribution network to help drive top-line growth.

Net sales to SpineView were $0.3 million and $0.4 million in the second quarter and first half of fiscal 2012, respectively, representing increases of $0.3 million (370%) and $0.4 million (476%) over the same periods in fiscal 2011. We continue to fulfill the initial stocking order of 50 video surgical endoscope systems to SpineView.

Net sales of repairs, peripherals, and accessories were $0.5 million and $1.0 million in the second quarter and first half of fiscal 2012, respectively, representing increases of $0.1 million (49%) and $0.4 million (57%) over the same periods in fiscal 2011. The increased demand of peripherals and accessories for our urology endoscopes as a result of the Stryker Agreement contributed to the year-over-year growth.
  
 
19

 

Gross Profit (Net Sales Less Cost of Sales)
 
Gross profit by operating segment for the three and six months ended September 30, 2011 and 2010 was as follows:
 
   
Three Months Ended
         
Six Months Ended
       
   
September 30,
         
September 30,
       
Gross Profit
 
2011
   
2010
   
Change
   
2011
   
2010
   
Change
 
Medical
  $ 1,143     $ 447       156 %   $ 2,043     $ 969       111 %
  As percentage of net sales
    34 %     26 %     8 %     31 %     25 %     6 %
Industrial
    254       194       31 %     482       361       34 %
  As percentage of net sales
    40 %     32 %     8 %     37 %     32 %     5 %
Gross profit
  $ 1,397     $ 641       118 %   $ 2,525     $ 1,330       90 %
Gross margin percentage
    35 %     28 %     7 %     32 %     27 %     5 %
 
Gross profit was $1.4 million and $2.5 million in the second quarter and first half of fiscal 2012, respectively, representing increases of $0.8 million (118%) and $1.2 million (90%) over the same periods in fiscal 2011. Gross margin percentage was 35% and 32% in the second quarter and first half of fiscal 2012, respectively, representing an increase of 7% and 5% over the same periods in fiscal 2011. The year-over-year increases in gross margin are largely driven by a more favorable sales mix towards products with higher gross margins and favorable manufacturing overhead absorption as a result of the higher production volume of our urology endoscopes and EndoSheath disposables.

Operating Expenses

Operating expenses by operating segment for the three and six months ended September 30, 2011 and 2010 were as follows:
 
   
Three Months Ended
         
Six Months Ended
       
   
September 30,
         
September 30,
       
Operating Expenses
 
2011
   
2010
   
Change
   
2011
   
2010
   
Change
 
SG&A expenses
                                   
Medical
  $ 3,143     $ 2,553       23 %   $ 5,712     $ 4,777       20 %
Industrial
    320       242       32 %     677       496       36 %
Total SG&A expenses
    3,463       2,795       24 %     6,389       5,273       21 %
R&D expenses
                                               
Medical
    739       732       1 %     1,431       1,330       8 %
Industrial
    -       -       -       -       -       -  
Total R&D expenses
    739       732       1 %     1,431       1,330       8 %
Total operating expenses
  $ 4,202     $ 3,527       19 %   $ 7,820     $ 6,603       18 %
 
Selling, General, & Administrative (“SG&A”) Expenses

SG&A expenses increased $0.7 million, or 24%, to $3.5 million during the second quarter of fiscal 2012 compared to the same period last year, and increased $1.1 million, or 21%, to $6.4 million during the first half of fiscal 2012 compared to the same period last year. These increases were primarily attributable to higher stock-based compensation expense, higher sales commissions with the overall growth of our net sales, and increased spending on sales and marketing consulting activities. Prior year SG&A expenses benefited from the recovery of bad debt expense for a delinquent account, which was not repeated in the current fiscal year and also contributed to the year-over-year increase.

Research & Development (“R&D”) Expenses
 
R&D expenses increased $7 thousand, or 1%, to $739 thousand during the second quarter of fiscal 2012 compared to the same period last year, and increased $101 thousand, or 8%, to $1.4 million during the first half of fiscal 2012 compared to the same period last year. These increases were primarily attributable to higher product development costs associated with our next generation digital processing units. We remain committed to improving the quality of our existing products and enhancing our product offerings with new technologies.

 
20

 

Other (Expense) Income
 
Other (expense) income for the three and six months ended September 30, 2011 and 2010 was as follows:
 
   
Three Months Ended
         
Six Months Ended
       
   
September 30,
         
September 30,
       
Other (Expense) Income
 
2011
   
2010
   
Change
   
2011
   
2010
   
Change
 
Interest income
  $ 2     $ 1       100 %   $ 7     $ 3       133 %
Interest expense
    (99 )     (90 )     10 %     (198 )     (145 )     37 %
Debt cost expense
    (43 )     (36 )     19 %     (84 )     (63 )     33 %
Other, net
    (10 )     1       -1100 %     (11 )     -       n/m *
Other expense
  $ (150 )   $ (124 )     21 %   $ (286 )   $ (205 )     40 %

* not meaningful

Total other expense increased $26 thousand, or 21%, to $150 thousand during the second quarter of fiscal 2012 compared to the same period last year, and increased $81 thousand, or 40%, to $286 thousand during the first half of fiscal 2012 compared to the same period last year. These increases are primarily attributable to the accrued interest on the outstanding borrowings under the Loan and the amortization of the deferred debt cost associated with the warrant shares issued in connection with the Loan.

Net Loss
 
Net loss for the three and six months ended September 30, 2011 and 2010 was as follows:
 
Net loss decreased $61 thousand, or -2%, to $3.0 million during the second quarter of fiscal 2012 compared to the same period last year, primarily attributable to a higher gross profit, partially offset by an increase in SG&A expenses. Net loss increased $100 thousand, or 2%, to $5.6 million in the first half of fiscal 2012 compared to the same period last year, primarily attributable to higher expenses, which more than offset the increase in gross profit.

Liquidity and Capital Resources

The following table summarizes selected financial information and statistics as of September 30, 2011 and March 31, 2011:
 
   
September 30,
   
March 31,
 
   
2011
   
2011
 
Cash and cash equivalents
  $ 2,866     $ 9,180  
Accounts receivable, net
  $ 1,672     $ 1,592  
Inventories, net
  $ 6,307     $ 6,096  
Working capital
  $ 6,231     $ 9,033  
 
At September 30, 2011, our principal source of liquidity was working capital of approximately $6.2 million, including $2.9 million in cash and cash equivalents. Our cash and cash equivalents decreased $6.3 million during the first half of fiscal 2012. The decrease was primarily attributable to cash used to fund our operations and cover the net loss sustained during the period.  Increased inventories to support a sales backlog of $3.0 million at September 30, 2011 also contributed to the increase in cash used during the first half of fiscal 2012.

In the first half of fiscal 2012, we used $7.5 million of net cash in our operating activities compared to $0.5 million in the first half of fiscal 2011. The increase in cash used in operations was primarily attributable to the reduction of advances from customers (i.e., sales of products to customers who already prepaid for such products in fiscal 2011) and higher inventories to support expected orders to fulfill the remaining customer advances. The first half of fiscal 2011 benefited from the receipt of these customer advances, which was not repeated in the current fiscal year.

In the first half of fiscal 2012, we used $0.1 million of net cash in our investing activities compared to the $0.4 million provided by such activities in the first half of fiscal 2011. The first half of fiscal 2011 benefited from the proceeds yielded from sales and maturities of our short-term investments.

In the first half of fiscal 2012, we provided $1.3 million of net cash from our financing activities compared to $2.1 million in the first half of fiscal 2011. The decrease was primarily attributable to a lower Advance taken on the Loan during the first half of fiscal 2012.
 
 
21

 
 
We have incurred losses since our inception, and losses are expected to continue through at least fiscal years 2012 and 2013. We have funded the losses principally with cash flow from operations, advances under a $10.0 million revolving loan agreement with the Lender, proceeds from equity financings (most recently the $10.5 million of proceeds we received from a private placement in January 2011), payments from Medtronic related to the sale of certain assets related to our ENT EndoSheath technology business, and the sale of other assets. We also received an aggregate of $6.4 million of deposits from two customers (the “Prepayments”) during fiscal 2011 to support anticipated sales orders, some of which have shipped through the second quarter of fiscal 2012 and the remainder are expected to ship over the course of the next few quarters. We have invested some of our working capital in inventory to fulfill these orders and forecasts provided from Stryker. We believe that our cash at September 30, 2011 will be sufficient to fund our working capital needs, capital expenditures, and future operating losses through September 30, 2012. However, if our performance expectations fall short (including 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. If required, we believe we would be able to reduce our expenses to a sufficient level.

Off-Balance Sheet Arrangements

We have no off-balance sheet arrangements that have, or are reasonably likely to have, a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures, or capital resources.

Item 3.  Quantitative and Qualitative Disclosures About Market Risk

We are a smaller reporting company, as defined in Rule 12b-2 of the Exchange Act, and are not required to provide the information required by this item.

Item 4.  Controls and Procedures

Disclosure Controls and Procedures

We have evaluated, under the supervision and with the participation of our senior management, including our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), the effectiveness of the design and operation of our disclosure controls and procedures as of September 30, 2011. Based upon the foregoing, our CEO and CFO concluded that our disclosure controls and procedures were effective as of September 30, 2011.
  
Changes in Internal Controls Over Financial Reporting
 
There have been no changes in our internal controls over financial reporting during the three and six months ended September 30, 2011 that have materially affected, or are reasonably likely to materially affect our internal controls over financial reporting.

 
22

 

PART II—OTHER INFORMATION

Item 1.  Legal Proceedings
 
None
 
Item 1A.  Risk Factors
 
There have been no material changes from the information discussed in Part I, Item 1A. Risk Factors, on page 19 of our Annual Report on Form 10-K for the year ended March 31, 2011, except for the information discussed below. You should carefully consider the risks and uncertainties we discussed in our Form 10-K and the risks described below in this quarterly report before deciding to invest in, or retain, shares of our common stock. These are not the only risks and uncertainties that we face. Additional risks and uncertainties that we do not currently know about or that we currently believe are immaterial, or that we have not predicted, may also harm our business operations or adversely affect us. If any of these risks or uncertainties actually occurs, our business, financial condition, operating results, or liquidity could be materially harmed.

We have a history of operating losses and we may not achieve or maintain profitability in the future

We have incurred substantial operating losses since our inception and there can be no assurance that we will achieve a profitable level of operations in the future. We anticipate a negative cash flow during fiscal years 2012 and 2013, because of spending for research and development, increasing our global network of independent sales representatives and distributors, continued investment in a direct sales force for the North American market, general business operations, and capital expenditures. As of September 30, 2011, we had cash and cash equivalents totaling approximately $2.9 million. We expect that our current balance of cash and $4 million of capital available, subject to certain conditions, under the Loan will be sufficient to fund our operations until September 30, 2012. However, if our performance expectations fall short (including 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. If required, we believe we would be able to reduce our expenses to a sufficient level.

Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds
 
The following table sets forth information on repurchases by us of our common stock during the three months ended September 30, 2011.
 
Fiscal Period
 
Total
Number of
Shares
Purchased
   
Average
Price
Paid
Per Share
   
Total Number of
Shares Purchased as
Part of Publicly
Announced Programs
   
Maximum Number of
Shares that May Yet
Be Purchased Under
the Programs
 
07/01/11 - 07/31/11
    -     $ -       -       -  
08/01/11 - 08/31/11
    -       -       -       -  
09/01/11 - 09/30/11
    1,634       1.92       -       -