**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D. C. 20459**

 

**FORM 10-Q**

 

**QUARTERLYREPORT UNDER SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**FOR THE QUARTER ENDED June 30, 2003**

 

**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) |
|                                                                                |   |                                  |
| **9 Strathmore Road, Natick, MA**                                                   |   | **01760**                             |
| (Address of principal executive offices)                                            |   | (Zip Code)                            |
|                                                                                |   |                                  |
| **(508) 650-9971**                                                                  |
| (Registrant’s telephone number, including area code)                           |
|                                                                                |   |                                  |
| **None**                                                                            |
| (Former name, former address, and  former fiscal year if changed since last report) |

 

Indicate bycheck mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirement for the past 90 days.

 

Yes  ý       No  o

 

Indicate bycheck mark whether the registrant is an accelerated filer (as defined in Rule12b-2 of the Exchange Act).

 

Yes  o       No  ý

 

Indicate thenumber of shares outstanding of each of the issuer’s classes of common stock,as of July 31, 2003.

 
| **Common Stock, par value of $.01** | **30,112,378**     |
|-------------------------------------|--------------------|
| (Title of Class)                    | (Number of Shares) |

 

 

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**VISION-SCIENCES, INC.**

**TABLE OF CONTENTS**

 
|     |                  | **Page**                                                                                    |
|----------|-----------------------|---------------------------------------------------------------------------------------------|
| Part I.  | Financial Information |                                                                                        |
|     |                  |
|     | Item 1.               | Financial Statements                                                                        |
|     |                  |
|     |                  | Consolidated Balance Sheets                                                                 | 3 |
|     |                  |                                                                                        |   |
|     |                  | Consolidated Statements of Operations                                                       | 4 |
|     |                  |                                                                                        |   |
|     |                  | Consolidated Statement of Stockholders’  Equity                                        | 5 |
|     |                  |                                                                                        |   |
|     |                  | Consolidated Statements of Cash Flows                                                       | 6 |
|     |                  |                                                                                        |   |
|     |                  | Notes to Consolidated Financial Statements                                                  | 7-12 |
|     |                  |
|     | Item 2.               | Management’s Discussion and Analysis of  Financial Condition and Results of Operations | 13-19 |
|     |                  |                                                                                        |
|     | Item 3.               | Quantitative and Qualitative Disclosures  about Market Risk                                 | 20 |
|     |                  |                                                                                        |
|     | Item 4.               | Controls and Procedures                                                                     | 21 |
|     |                  |                                                                                        |
| Part II. | Other Information     |
|     |                  |                                                                                        |
|     | Item 5.               | Other Information                                                                           | 22 |
|     |                  |                                                                                        |
|     | Item 6.               | Exhibits and Reports on Form 8-K                                                            | 22 |
|     |                  |                                                                                        |
|     | Signatures            | 23                                                                                          |
|     |                  |                                                                                        |
|     | Exhibits              | 23-26                                                                                       |

 

2

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**PART I****- FINANCIALINFORMATION**

**Item1****: FINANCIAL STATEMENTS**

 

**VISION-SCIENCES, INC.AND SUBSIDIARIES**

**CONSOLIDATED BALANCE SHEETS**

**(Unaudited)**

 
|                                                                                                    |   | **June 30,  2003** |      | **March 31,  2003** |   |
|---------------------------------------------------------------------------------------------------------|--------|--------------------|-----------|---------------------|--------|
| ASSETS                                                                                                  |   |               |      |                |   |
| Current  Assets:                                                                                        |   |               |      |                |   |
| Cash and cash equivalents                                                                               |   | $                  | 2,705,443 |                | $      | 2,744,143 |   |
| Marketable securities                                                                                   |   | 125,384            |      | 125,072             |   |
| Accounts receivable, net of allowance for  doubtful accounts of $74,037 and $77,185, respectively       |   | 982,694            |      | 736,711             |   |
| Inventories                                                                                             |   | 1,141,480          |      | 1,160,372           |   |
| Prepaid expenses and deposits                                                                           |   | 51,831             |      | 51,113              |   |
| Total current assets                                                                                    |   | 5,006,832          |      | 4,817,411           |   |
|                                                                                                    |   |               |      |                |   |
| Property and Equipment, at cost:                                                                        |   |               |      |                |   |
| Machinery and equipment                                                                                 |   | 3,412,070          |      | 3,393,099           |   |
| Furniture and fixtures                                                                                  |   | 209,813            |      | 208,934             |   |
| Leasehold improvements                                                                                  |   | 467,620            |      | 467,620             |   |
|                                                                                                    |   | 4,089,503          |      | 4,069,653           |   |
| Less-Accumulated depreciation and amortization                                                          |   | 3,583,879          |      | 3,529,977           |   |
|                                                                                                    |   | 505,624            |      | 539,676             |   |
|                                                                                                    |   |               |      |                |   |
| Advance to Three BY Ltd                                                                                 |   | 69,978             |      | —              |   |
|                                                                                                    |   |               |      |                |   |
| Other assets, net of accumulated  amortization of $42,673 and $41,087, respectively                     |   | 88,173             |      | 89,759              |   |
| Total assets                                                                                            |   | $                  | 5,670,607 |                | $      | 5,446,846 |   |
|                                                                                                    |   |               |      |                |   |
| LIABILITIES  AND STOCKHOLDERS’ EQUITY                                                              |   |               |      |                |   |
| Current Liabilities:                                                                                    |   |               |      |                |   |
| Acceptances payable to a bank                                                                           |   | $                  | 17,469    |                | $      | 10,621 |   |
| Accounts payable                                                                                        |   | 425,126            |      | 294,312             |   |
| Accrued expenses                                                                                        |   | 800,421            |      | 804,139             |   |
| Total current liabilities                                                                               |   | 1,243,016          |      | 1,109,072           |   |
|                                                                                                    |   |               |      |                |   |
| Potential obligations to non-qualified  option holders                                                  |   | 255,517            |      | 201,648             |   |
|                                                                                                    |   |               |      |                |   |
| Stockholders’ Equity:                                                                              |   |               |      |                |   |
| Common stock, $.01 par value–                                                                      |   |               |      |                |   |
| Authorized—50,000,000 shares                                                                       |   |               |      |                |   |
| Issued and outstanding—30,112,378 shares at  June 30, 2003 and 29,588,280 shares at March 31, 2003 |   | 301,123            |      | 295,882             |   |
| Additional paid-in capital                                                                              |   | 60,431,085         |      | 60,082,930          |   |
| Accumulated deficit                                                                                     |   | (56,560,134        | )         | (56,242,686         | )      |
| Total stockholders’ equity                                                                         |   | 4,172,074          |      | 4,136,126           |   |
| Total liabilities and stockholders’ equity                                                         |   | $                  | 5,670,607 |                | $      | 5,446,846 |   |

 

See accompanying notes to consolidated financial statements.

 

3

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**VISION-SCIENCES, INC.AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

**(Unaudited)**

 
|                                                                  |   | **Three Months Ended  June 30,** |      |
|-----------------------------------------------------------------------|--------|----------------------------------|-----------|
|                                                                  |   | **2003**                         |      | **2002** |   |
|                                                                  |   |                             |      |   |   |
| Net sales                                                             |   | $                                | 1,960,482 |   | $ | 1,734,459 |   |
| Cost of sales                                                         |   | 1,202,897                        |      | 1,272,486 |   |
|                                                                  |   |                             |      |   |   |
| Gross profit                                                          |   | 757,585                          |      | 461,973 |   |
|                                                                  |   |                             |      |   |   |
| Selling, general and administrative  expenses (1)                     |   | 871,424                          |      | 788,058 |   |
| Research and development expenses (1)                                 |   | 159,639                          |      | 94,540 |   |
| Stock-based compensation                                              |   | 55,753                           |      | (94,507 | ) |
| Loss from operations                                                  |   | (329,231                         | )         | (326,118 | ) |
|                                                                  |   |                             |      |   |   |
| Interest income                                                       |   | 8,172                            |      | 12,147 |   |
| Interest expense                                                      |   | —                           |      | (578 | ) |
| Other income, net                                                     |   | 3,611                            |      | 7,421 |   |
|                                                                  |   |                             |      |   |   |
| Net loss                                                              |   | $                                | (317,448  | ) | $ | (307,128 | ) |
|                                                                  |   |                             |      |   |   |
| Basic and diluted net loss per common share                           |   | $                                | (0.01     | ) | $ | (0.01 | ) |
|                                                                  |   |                             |      |   |   |
| Shares used in computing basic and diluted  net loss per common share |   | 29,987,202                       |      | 27,185,845 |   |

 

----

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

 
| Research and development expenses             |   | $      | 37,393 |   | $      | (174,361 | ) |
|-----------------------------------------------|--------|--------|--------|--------|--------|----------|---|
| Selling, general and administrative  expenses |   | 18,360 |   | 79,854 |   |
| Total                                         |   | $      | 55,753 |   | $      | (94,507  | ) |

 

See accompanying notes to consolidated financial statements.

 

4

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**VISION-SCIENCES, INC.AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENT OF STOCKHOLDERS’ EQUITY**

**(Unaudited)**

 
|                                                                  |   | **Common  Stock**     |   | **Additional  Paid-in-Capital** |    | **Accumulated  Deficit** |   | **Total  Stockholders’  Equity** |   | **Total  Comprehensive  Loss** |        |
|-----------------------------------------------------------------------|--------|-----------------------|--------|---------------------------------|---------|--------------------------|--------|---------------------------------------|--------|--------------------------------|-------------|
|                                                                  |   | **Number  of Shares** |   | **$ .01  Par Value**            |    |                     |   |                                  |   |
|                                                                  |   |                  |   |                            |    |                     |   |
|                                                                  |   |                  |   |                            |    |                     |   |                                  |   |                           |        |   |   |
| Balance, March 31, 2003                                               |   | 29,588,280            |   | $                               | 295,882 |                     | $      | 60,082,930                            |   | $                              | (56,242,686 | ) | $ | 4,136,126 |   |   |   |
| Sale of common stock                                                  |   | 524,098               |   | 5,241                           |    | 346,271                  |   | —                                |   | 351,512                        |        |   |   |
| Compensation expense related to employee  non-qualified stock options |   |                  |   |                            |    | 1,884                    |   | —                                |   | 1,884                          |        |   |   |
| Net loss                                                              |   | —                |   | —                          |    | —                   |   | (317,448                              | )      | (317,448                       | )           | $ | (317,448 | ) |
|                                                                  |   |                  |   |                            |    |                     |   |                                  |   |                           |        |   |   |
| Total comprehensive loss                                              |   |                  |   |                            |    |                     |   |                                  |   |                           |        | $ | (317,448 | ) |
|                                                                  |   |                  |   |                            |    |                     |   |                                  |   |                           |        |   |   |
| Balance June 30, 2003                                                 |   | 30,112,378            |   | $                               | 301,123 |                     | $      | 60,431,085                            |   | $                              | (56,560,134 | ) | $ | 4,172,074 |   |   |   |

 

See accompanying notes to consolidated financial statements.

 

5

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**VISION-SCIENCES, INC.AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(Unaudited)**

 
|                                                                                              |   | **Three Months Ended  June 30, 2003** |      | **Three Months Ended  June 30, 2002** |   |
|---------------------------------------------------------------------------------------------------|--------|---------------------------------------|-----------|---------------------------------------|--------|
| Cash flows from operating activities:                                                             |   |                                  |      |                                  |   |
| Net loss                                                                                          |   | $                                     | (317,448  | )                                     | $      | (307,128 | ) |
| Adjustments to reconcile net loss to net  cash used for operating activities:                     |   |                                  |      |                                  |   |
| Depreciation and amortization                                                                     |   | 55,488                                |      | 52,408                                |   |
| Stock compensation for non-qualified  options                                                     |   | 55,753                                |      | (94,507                               | )      |
| Changes in assets and liabilities:                                                                |   |                                  |      |                                  |   |
| Accounts receivable                                                                               |   | (245,983                              | )         | (106,590                              | )      |
| Inventories                                                                                       |   | 18,892                                |      | (151,562                              | )      |
| Prepaid expenses and deposits                                                                     |   | (718                                  | )         | (6,853                                | )      |
| Accounts payable                                                                                  |   | 130,814                               |      | 295,818                               |   |
| Accrued expenses                                                                                  |   | (3,718                                | )         | (154,357                              | )      |
| Net cash used for operating activities                                                            |   | (306,920                              | )         | (472,771                              | )      |
| Cash flows used for investing activities                                                          |   |                                  |      |                                  |   |
| Increase in marketable securities                                                                 |   | (312                                  | )         | (849,520                              | )      |
| Purchase of property and equipment, net                                                           |   | (19,850                               | )         | (25,754                               | )      |
| Advance to Three BY Ltd                                                                           |   | (69,978                               | )         | —                                |   |
|                                                                                              |   |                                  |      |                                  |   |
| Net cash used for investing activities                                                            |   | (90,140                               | )         | (875,274                              | )      |
|                                                                                              |   |                                  |      |                                  |   |
| Cash flows provided by (used for) financing  activities:                                          |   |                                  |      |                                  |   |
| Payments on note payable for leasehold  improvements......                                  |   | —                                |      | (14,250                               | )      |
| (Payments for) proceeds from acceptances  payable to a bank                                       |   | 6,848                                 |      | (6,315                                | )      |
| Proceeds from the sale of common stock, net                                                       |   | 351,512                               |      | —                                |   |
| Exercise of stock options                                                                         |   | —                                |      | 20,501                                |   |
| Net cash (used for) provided by financing  activities                                             |   | 358,360                               |      | (64                                   | )      |
| Net (decrease) increase in cash and cash  equivalents                                             |   | (38,700                               | )         | (1,348,109                            | )      |
| Cash and cash equivalents, beginning of  period                                                   |   | 2,744,143                             |      | 2,890,364                             |   |
| Cash and cash equivalents, end of period                                                          |   | $                                     | 2,705,443 |                                  | $      | 1,542,255 |   |
|                                                                                              |   |                                  |      |                                  |   |
| Supplemental Disclosure of Cash Flow  Information:                                                |   |                                  |      |                                  |   |
| Cash paid during the period for interest                                                          |   | $                                     | —    |                                  | $      | 578 |   |
|                                                                                              |   |                                  |      |                                  |   |
| Supplemental Disclosure of Non-cash Items  from Financing Activities:                             |   |                                  |      |                                  |   |
| Exercise of non-qualified options  transferred to equity during the period                        |   | $                                     | —    |                                  | $      | 104,452 |   |
|                                                                                              |   |                                  |      |                                  |   |
| Fair market value of non-qualified options  granted in the period..                               |   | $                                     | 1,411,550 |                                  | $      | 79,854 |   |
|                                                                                              |   |                                  |      |                                  |   |
| Change in the fair market value of non-qualified  options existing at the beginning of the period |   | $                                     | 53,869    |                                  | $      | (174,361 | ) |

 

See accompanying notes to consolidated financial statements.

 

6

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**VISION-SCIENCES, INC.AND SUBSIDIARIES**

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**(Unaudited)**

 

**1**.                                      **Basis ofPresentation**

 

Theconsolidated financial statements included herein have been prepared by theCompany in accordance with accounting principles generally accepted in theUnited States of America, without audit, pursuant to the rules and regulationsof the Securities and Exchange Commission and include, in the opinion ofmanagement, all adjustments (consisting only of normal and recurringadjustments) that the Company considers necessary for a fair presentation ofsuch information.  Certain informationand footnote disclosures normally included in financial statements have beencondensed or omitted pursuant to such rules and regulations.  The Company believes, however, that itsdisclosures are adequate to make the information presented not misleading.  These consolidated financial statementsshould be read in conjunction with the audited consolidated financialstatements and notes thereto included in the Company’s latest annual report tostockholders.  The results for theinterim periods presented are not necessarily indicative of results to beexpected for the full fiscal year.

 

**2**.                                      **Summary ofSignificant Accounting Policies**

 

Theaccompanying consolidated financial statements reflect the application ofcertain accounting policies described below:

 

a.                                       *Principlesof Consolidation*: The accompanying consolidated financial statementsinclude the accounts of the Company and its wholly-owned subsidiaries.  All material intercompany accounts andtransactions have been eliminated in consolidation.

 

b**.****                                     ***CashEquivalents*: Cash equivalents are carried at market value, whichapproximates amortized cost*.** *Cashequivalents are short-term, highly liquid investments with original maturitiesof less than three months.

 

c.                                       *MarketableSecurities*: Marketable securities are carried at market value, whichapproximates amortized cost.  TheCompany has classified its investments in marketable securities asavailable-for-sale securities.  At June30, 2003, the Company’s marketable securities consisted of a certificate ofdeposit with a maturity of 182 days.

 

d.                                      *Inventories*:  Inventories are stated at the lower of costor market using the first-in, first-out (FIFO) method and consist of thefollowing:

 
|            |   | **June 30,  2003** |      | **March 31,  2003** |   |
|-----------------|--------|--------------------|-----------|---------------------|--------|
|            |   |               |      | **(audited)**       |   |
| Raw materials   |   | $                  | 604,937   |                | $      | 567,008 |   |
| Work-in-process |   | 183,546            |      | 155,723             |   |
| Finished goods  |   | 352,997            |      | 437,641             |   |
|            |   | $                  | 1,141,480 |                | $      | 1,160,372 |   |

 

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

 

7

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e.                                       *Depreciationand*Amortization: The Company provides for depreciation andamortization using the straight-line method in amounts that allocate the costof the assets to operations over their estimated useful lives as follows:

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

 

Leaseholdimprovements are amortized over the shorter of their estimated useful lives orthe lives of the leases.

 

f.                                         *Basic andDiluted Net Loss Per Common Share*: Basic and diluted net loss percommon share is based on the weighted average number of common sharesoutstanding.  Shares of common stockissuable pursuant to outstanding stock options have not been considered, astheir effect would be antidilutive.

 

g.                                      *RevenueRecognition*: The following must occur before the Company recognizesrevenue: (1) persuasive evidence of an arrangement exists, (2) delivery hasoccurred or services have been rendered, (3) the price is fixed ordeterminable, (4) collectibility is reasonably assured and (5) the fair valueof undelivered elements, if any, exists.

 

h.                                      *ForeignCurrency Transactions*: In accordance with Statement of FinancialAccounting Standard (“SFAS”) No. 52, *Foreign Currency Translation,* the Companycharges foreign currency exchange gains or losses, in connection with itspurchases of products from vendors in Japan, to operations, and charges foreignexchange translation gains and losses to retained earnings.

 

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

 

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

 

8

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j.                                          *Accountingfor Derivatives*: In September 2000, the Emerging Issues Task Force(“EITF”) issued EITF 00-19, *Accounting for Derivative Financial InstrumentsIndexed to, and Potentially Settled in, a Company’s Own Stock*, whichrequires freestanding contracts that are settled in a company’s own stock,including common stock options and warrants, to be designated as an equityinstrument, an asset or a liability. Under the provisions of EITF 00-19, a contract designated as an asset ora liability must be carried at fair value, with any changes in fair valuerecorded in the results of operations. A contract designated as an equity instrument must be included withinequity, and no fair value adjustments are required.

 

In accordancewith EITF 00-19, the Company has determined that outstanding options tonon-employees as of June 30, 2003 to purchase 1,463,032 shares of the Company’scommon stock should be designated as a liability.

 

The Companyvalued the non-qualified options outstanding to non-employees at June 30, 2003and 2002 using the Black-Scholes method. The value of those options increased by $53,869 and decreased by $94,507in the three months ended June 30, 2003 and 2002, respectively.  The Company recorded the charge or credit tostock-based compensation in the accompanying statements of operations for theseperiods.

 

k.                                       *EmployeeStock-based Compensation Arrangements:*The Company accounts for itsemployee stock-based compensation arrangements using the intrinsic value methodunder the provisions of Accounting Principles Board Opinion No. 25, *Accountingfor Stock Issued to Employees*, and Financial Interpretation No.(“FIN”) 44.  The Company does notrecognize stock-based employee compensation cost when the options granted havean exercise price equal to, or greater than, the market value of the underlyingcommon stock on the date of the grant. The Company does recognize stock-based employee compensation cost whenthe options granted have an exercise price less than the market value of theunderlying common stock on the date of the grant.

 

In June 2003,the Company granted options to purchase 1,295,000 shares of common stock to itsemployees at an exercise price of $1.04 per share.  The fair market value of the common stock on the date of grantwas $1.09 per share.  As a result, theCompany will recognize compensation expense for the difference between the fairmarket value and the option price over the life of the options.  In the three months ended June 30, 2003, theCompany recognized $1,884 of expense as stock-based compensation in theconsolidated statement of operations.

 

9

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k.                                       *EmployeeStock-based Compensation Arrangements: (Continued)*

 

In accordancewith the Financial Accounting Standards Board (FASB) Statement No. 148, *Accountingfor Stock-Based Compensation – Transition and Disclosure*, beginningin the quarter ending March 31, 2003, the Company adopted the disclosurerequirements of FASB No. 148.  Hadcompensation expense for all stock option grants to employees been determinedunder the fair value method at the grant dates, consistent with the methodprescribed by SFAS No. 123, the Company’s net loss would have been increased tothe pro forma amounts indicated as follows:

 
|                                                  |   | **Three Months Ended June 30,** |     |
|-------------------------------------------------------|--------|---------------------------------|----------|
|                                                  |   | **2003**                        |     | **2002** |   |
| Net loss – as reported                           |   | $                               | (317,448 | ) | $ | (307,128 | ) |
| Stock-based employee compensation – as  reported |   | 1,884                           |     | — |   |
| Pro forma stock-based employee compensation           |   | (69,000                         | )        | (86,300 | ) |
| Net loss - pro forma                                  |   | $                               | (384,564 | ) | $ | (393,428 | ) |
|                                                  |   |                            |     |   |   |
| Net loss per share – as reported                 |   | $                               | (.01     | ) | $ | (.01 | ) |
| Stock-based employee compensation – as  reported |   | —                          |     | — |   |
| Pro forma stock-based employee compensation           |   | —                          |     | — |   |
| Net loss per share - pro forma                        |   | $                               | (.01     | ) | $ | (.01 | ) |

 

*l.**                                         RecentlyIssued*Accounting*Standards*

 

In May 2003,FASB issued SFAS No. 150, *Accounting for Certain Financial Instruments withCharacteristics of Both Liabilities and Equity*.  SFAS No. 150 is the first phase of theFASB’s project on liabilities and equity. SFAS No. 150 provides guidance on how an entity classifies and measurescertain financial instruments with characteristics of both liabilities andequity.  Many of these instruments werepreviously classified as equity.  Forexample, if an employer’s issuance of its shares to a key employee requires theemployer to redeem the shares upon the employee’s death, then those shares mustbe classified as a liability, not as equity. For publicly-held companies, SFAS No. 150 is effective for financialinstruments entered into or modified after May 31, 2003.  SFAS No. 150 requires companies to recordthe cumulative effect of financial instruments existing at the adoptiondate.  The Company does not believe theadoption of SFAS 150 will have a significant effect on the Company’soperations, financial position or cash flows.

 

10

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*l.**                                         RecentlyIssued Accounting Standards: (Continued)*

 

In November2002, the EITF reached consensus on EITF No. 00-21, *Revenue Arrangements with MultipleDeliverables*.  Revenuearrangements with multiple deliverables include arrangements that provide forthe delivery or performance of multiple products, services and/or rights to useassets where performance may occur at different points in time or overdifferent periods of time.  The Companymay enter into arrangements for multiple deliverables that occur at differentpoints in time if it enters into a contract to sell endoscopes and EndoSheathson a per-procedure basis.  EITF No.00-21 is effective for the Company beginning October 1, 2003.  The Company has not completed the evaluationof the impact, if any, of this EITF on its operations.

 

**3.****                                      3DVSystems Ltd.**

 

The Companyaccounts for its investment in 3DV Systems Ltd. (“3DV”) using the equity methodof accounting.  As of June 30, 2003, theCompany owned approximately 21% of the outstanding shares of 3DV, and wouldhold approximately 17% of the shares of 3DV, if all employee options andConvertible Notes were converted to common shares.  The Company’s investment in 3DV totaled $0 at March 31, 2003, andaccordingly, the Company did not recognize any portion of the losses of 3DV forthe three months ended June 30, 2003.

 

**4.****                                      ThreeBY Ltd.**

 

In June 2003,the Company entered into a Contract Manufacturing Agreement, a Loan Agreementand a Pledge Agreement (collectively, the “3BY Agreements”) with Three BY Ltd.,an Israeli company (“3BY”).  The 3BYAgreements provide for, among other things, the manufacture of certain of theCompany’s products by 3BY, and a loan of up to $267,500 by the Company to 3BYfor the purchase and installation of certain manufacturing equipment by 3BY, at3BY’s facility, to be used to manufacture certain of the Company’sproducts.  As of June 30, 2003, theCompany had advanced $69,978 to 3BY, and expects to advance the complete loanby September 30, 2003.  After themanufacturing equipment is completed, and production has begun, the Company and3BY plan to establish a repayment schedule, according to the 3BY Agreements.

 

11

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**5.****                                      SegmentInformation**

 

The Companyhas three reportable segments – medical, industrial and corporate.  The medical segment designs, manufacturesand sells EndoSheaths and sells endoscopes to users in the health careindustry.  The industrial segmentdesigns, manufactures and sells borescopes to a variety of users, primarily inthe aircraft engine manufacturing and aircraft engine maintenance industries.  In addition, the industrial segmentmanufactures and repairs endoscopes for the medical segment.  The corporate segment consists of certainadministrative expenses applicable to the Company as a whole and the managementoversight of the Company’s investment in 3DV, Vision-Sciences Ltd. (theCompany’s Israeli subsidiary) and the Company’s support of the University ofGeorgia Hepatitis Project, Proposal No. 022297-01 (the “Egypt Project”).

 

All segmentsfollow the accounting policies described in the summary of significantaccounting policies.  The Companyevaluates segment performance based upon operating income.  Identifiable assets are those used directlyin the operations of each segment. Corporate assets include cash, marketable securities, the assets ofVision-Sciences, Ltd. and the investment in 3DV.  The carrying value of the investment in 3DV at June 30, 2003 was$0.  Data regarding management’s view ofthe Company’s segments are provided in the following tables.

 
| **Three months ended June 30,**                             |   | **Medical** |      | **Industrial** |   | **Corporate** |   | **Adjustments** |   | **Total** |   |
|-------------------------------------------------------------|--------|-------------|-----------|----------------|--------|---------------|--------|-----------------|--------|-----------|--------|
| **2003**                                                    |   |        |      |           |   |          |   |            |   |      |   |
| Sales to external customers                                 |   | $           | 1,271,017 |           | $      | 689,465       |   | $               | — |      | $      | — |   | $ | 1,960,482 |   |
| Intersegment sales                                          |   | —      |      | 146,384        |   | —        |   | (146,384        | )      | —    |   |
| Operating income (loss)                                     |   | 23,823      |      | (24,529        | )      | (328,525      | )      | —          |   | (329,231  | )      |
| Interest income (expense)                                   |   | —      |      | —         |   | 8,172         |   | —          |   | 8,172     |   |
| Depreciation and amortization                               |   | 45,532      |      | 9,956          |   | —        |   | —          |   | 55,488    |   |
| Advance to 3BY Ltd.                                         |   | 69,978      |      | —         |   | —        |   | —          |   | 69,978    |   |
| Other significant non-cash items:  Stock-based compensation |   | 107         |      | 36             |   | 55,610        |   | —          |   | 55,753    |   |
| Expenditures for fixed assets                               |   | 18,600      |      | 1,250          |   | —        |   | —          |   | 19,850    |   |
| Total assets                                                |   | 2,108,176   |      | 951,540        |   | 2,922,801     |   | (311,910        | )      | 5,670,607 |   |
|                                                        |   |        |      |           |   |          |   |            |   |      |   |
| **2002**                                                    |   |        |      |           |   |          |   |            |   |      |   |
| Sales to external customers                                 |   | $           | 1,008,006 |           | $      | 726,453       |   | $               | — |      | $      | — |   | $ | 1,734,459 |   |
| Intersegment sales                                          |   | —      |      | 202,873        |   | —        |   | (202,873        | )      | —    |   |
| Operating income (loss)                                     |   | (242,989    | )         | 4,834          |   | (87,963       | )      | —          |   | (326,118  | )      |
| Interest income (expense)                                   |   | —      |      | (578           | )      | 12,147        |   | —          |   | 11,569    |   |
| Depreciation and amortization                               |   | 44,216      |      | 8,192          |   | —        |   | —          |   | 52,408    |   |
| Advance to 3BY Ltd.                                         |   | —      |      | —         |   | —        |   | —          |   | —    |   |
| Other significant non-cash items:  Stock-based compensation |   | —      |      | —         |   | (94,507       | )      | —          |   | (94,507   | )      |
| Expenditures for fixed assets                               |   | 14,860      |      | 10,894         |   | —        |   | —          |   | 25,754    |   |
| Total assets                                                |   | 1,879,284   |      | 1,290,133      |   | 2,735,194     |   | (164,676        | )      | 5,739,935 |   |

 

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## **Item 2**.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF

## **FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

Critical AccountingPolicies and Estimates

 

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

 

### *Revenue Recognition*

 

We recognize revenue inaccordance with SEC Staff Accounting Bulletin No. 101, *Revenue Recognition in FinancialStatements*(SAB 101), as amended by SAB 101A and 101B, and EITF00-21.  These pronouncements requirethat five basic criteria must be met before revenue can be recognized: (1)persuasive evidence that an arrangement exists; (2) delivery has occurred orservices rendered; (3) the fee is fixed and determinable; (4) collectibility isreasonably assured and (5) the fair value of undelivered elements, if any,exists.  Determination of criterion (4)is based on management’s judgment regarding the collectibility of invoices forproducts and services delivered to customers. Determination of criterion (5) is based on management’s judgmentregarding the fair value of any undelivered elements of a contract.  Should changes in conditions causemanagement to determine these criteria are not met for certain futuretransactions, revenue recognized for any reporting period could be adverselyaffected.

 

# ***Potential Obligations to Non-qualifiedOption Holders***

 

Financial instruments,including derivatives and non-qualified options to purchase our common stock,require disclosure of an estimate of their fair values.  Fair values are based on listed marketprices, where possible.  We account forcertain non-qualified options granted to non-employees to purchase our commonstock in accordance the EITF 00-19, *Accounting for Derivative Financial InstrumentsIndexed to, and Potentially Settled in, a Company’s Own Stock*, andcarry these contracts at fair value, with any changes in fair value recorded inthe results of operations. Fair values for certain non-qualified options arederived from pricing models that consider current market and contractual pricesfor the underlying financial instruments or commodities, as well as time valueand yield curve or volatility factors underlying the positions.  Pricing models and their underlyingassumptions impact the amount and timing of unrealized gains and lossesrecognized, and the use of different pricing models or assumptions couldproduce different financial results. The Company uses the Black-Scholes method for determining the value ofthe potential obligation to non-qualified option holders.

 

We account for certainnon-qualified options granted to employees to purchase our common stock inaccordance with SFAS No. 123, *Accounting for**Stock-Based Compensation.*  If the fair market value of the underlyingstock at the date of grant is greater than the option price, we recognizecompensation expense for the difference between the market price and the optionprice over the life of the options.

 

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Results ofOperations

 

This Quarterly Report on Form10-Q contains forward-looking statements within the meaning of The PrivateSecurities Litigation Reform Act of 1995. Examples of forward-looking statements include statements aboutexpectations about future financial results, future products and future sales ofnew and existing products, future expenditures, and capital resources to meetanticipated requirements.  Withoutlimiting the foregoing, the words “believes”, “anticipates”, “plans”,“expects”, and similar expressions are intended to identify forward-lookingstatements.  These forward-lookingstatements involve risks and uncertainties, and our actual results may differsignificantly from those discussed in the forward-looking statements. Factorsthat might cause such a difference include, but are not limited to theavailability of capital resources, the availability of third-partyreimbursement, government regulation, the availability of supplies,competition, technological difficulties, general economic conditions and otherrisks detailed in our most recent Annual Report on Form 10-K and any subsequentperiodic filings made with the Securities and Exchange Commission.  We do not undertake an obligation to updateour forward-looking statements to reflect future events or circumstances.

 

We develop, manufacture andsell flexible endoscope products for the medical device and industrial devicemarkets.  We operate in three reportingsegments, medical, industrial and corporate.

 

The medical segment suppliesendoscopes and disposable EndoSheath® Systems (“EndoSheaths”) to theEar-Nose-Throat (“ENT”), gastrointestinal (“GI”) and pulmonary markets.  Health-care providers use EndoSheaths tocover the insertion tube of flexible endoscopes, such as ENT endoscopes,sigmoidoscopes and bronchoscopes.  TheEndoSheaths allow the health-care providers to process patients economically bypermitting the providers to avoid reprocessing the endoscopes after eachuse.  In addition, the EndoSheaths aresterile, thus helping to ensure each patient a contaminant-free procedure.

 

The industrial segment designs,manufactures and sells flexible endoscopes, termed borescopes, for industrialusers, and manufactures and repairs flexible endoscopes for the medicalsegment.  The industrial segment usersconsist primarily of companies in the aircraft engine manufacturing andmaintenance markets and the defense market.

 

The corporate segment consistsof certain administrative and business development activities applicable to thecompany as a whole, and management oversight of our investments in 3DV, VisionSciences, Ltd. and the Egypt Project.

 

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Sales

 

Net sales for the three monthsended June 30, 2003 (“Q1 04”) were $1,960,482, an increase of $226,023, or 13%,compared to the three-month period ended June 30, 2002 (“Q1 03”).  During Q1 04, sales of the medical segmentincreased by $263,011, or 26%, and sales of the industrial segment decreased by$36,988, or 5%, compared to Q1 03.  Inthe medical segment, the sales and changes in sales by market were as follows($000’s):

 
| **Market** |   | **Q1 04** |   | **Q1 03** |   | **Increase  (Decrease)** |   | **Percent** |   |
|------------|--------|-----------|--------|-----------|--------|--------------------------|--------|-------------|--------|
| ENT        |   | $         | 1,058  |      | $      | 828                      |   | $           | 230    |   | 28 | % |
| GI         |   | 151       |   | 119       |   | 32                       |   | 27          | %      |
| Pulmonary  |   | 15        |   | 27        |   | (12                      | )      | (44%        | )      |
| Other      |   | 47        |   | 34        |   | 13                       |   | 38          | %      |
| Total      |   | $         | 1,271  |      | $      | 1,008                    |   | $           | 263    |   | 26 | % |

 

Medical segment sales to theENT market include sales of our own ENT endoscope and ENT EndoSheaths for ourENT endoscope, and for the ENT endoscopes of most other majormanufacturers.  Sales to the GI andpulmonary markets include sales of our proprietary endoscopes and EndoSheathsfor use with those endoscopes.  Salestermed Other include repairs of our endoscopes and accessories.

 

In the ENT market, sales ofEndoSheaths increased by approximately $213,000, or 32%, compared to Q103.  In addition, sales of ENT endoscopesincreased by approximately $13,000, or 8%, compared to Q1 03.  The remainder of the increase in sales tothe ENT market was due to initial sales of our new ENT Channeled EndoSheath.  The ENT Channeled EndoSheath is designed toallow health-care providers to perform therapeutic procedures in their offices,using conventional diagnostic ENT endoscopes, that currently they can onlyperform using a therapeutic ENT endoscope that contains a channel, typically ina hospital setting.  The channel containedin the ENT Channeled EndoSheath allows the health-care provider to pass tools,such as biopsy forceps or brushes, through it, or to irrigate the sinus cavityof a patient, a common procedure after sinus surgery. Therapeutic ENTendoscopes are typically only found in hospital settings as they represent alarge investment.

 

This increase in sales of ENTEndoSheaths was due primarily to higher unit volume from the domestic andinternational markets.  Sales todomestic customers were approximately $399,000, an increase of approximately$36,000, or 10%, compared to Q1 03, with unit sales increasing to approximately37,000 from 33,700 in Q1 03.  Sales tointernational distributors were approximately $483,000, an increase ofapproximately $177,000, or 58%, with unit sales increasing to approximately82,800 from 52,400 in Q1 03.  Theincrease in sales to domestic customers resulted from higher demand from morecustomers and higher average usage from all customers who purchased product inQ1 04.  We believe this reflectsimprovements in our sales and distribution capabilities, our program ofdiscount pricing for new customers and our emphasis on the practiceefficiencies attained when using our ENT EndoSheath.

 

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On August 6, 2003, we enteredinto an exclusive marketing and distribution agreement (the “MedtronicAgreement”) with Medtronic Xomed, Inc. (“Medtronic Xomed”), which we expectwill become effective on or about September 17, 2003.  The initial term of the Medtronic Agreement is three years.  Thereafter, the Medtronic Agreement will beautomatically renewed for successive one-year periods, unless terminated byeither party upon advance written notice. Under the Medtronic Agreement, we have granted Medtronic Xomed exclusivedistribution rights in the United States and Canada to market and sell our ENTEndoSheaths and ENT endoscopes to ENT practitioners.  Medtronic Xomed has agreed to certain minimum purchaserequirements for the initial twelve-month period of the term.  We expect the Medtronic Agreement willresult in an increase in sales of our ENT EndoSheaths and ENT endoscopes due tothe significantly greater marketing and sales capabilities of Medtronic Xomed.  In addition, the Medtronic Agreement isexpected to facilitate the introduction of new ENT products by allowing quickermarket acceptance of these products.  Asa result of the Medtronic Agreement, the success of our ENT product lines willbe substantially dependent upon the success of the marketing and salesactivities of Medtronic Xomed over which we have limited control.

 

The increase in sales tointernational distributors is primarily due to higher demand, especially fromEurope and Australia.  In addition tocontinuing to promote our existing products to the international market, weplan to introduce our new products to these distributors.  Further, we continue to seek newdistributors who have a strong ENT presence in countries where we have norepresentation.  Our business is subjectto the typical risks associated with operating in international markets,including longer sales cycles, exposure to adverse changes in currency exchangerates and compliance with local customs, rules and regulations.  Despite the increase in sales tointernational distributors and our continuing marketing and sales efforts ininternational markets, there can be no assurance that our sales tointernational distributors will continue to increase at the same rate, or atall.

 

The increase in sales to the GI(Gastrointestinal) market was due primarily to higher prices for GIEndoSheaths, offset partially by lower demand due to reimbursement rates tohealth-care providers not being sufficient to support the use of our GIEndoSheaths for those gastrointestinal procedures.

 

The decrease in sales to thepulmonary market was due primarily to lower demand for our bronchoscopes.  In Q1 03 we sold two bronchoscopes, whereaswe sold none in Q1 04.  The sales cyclefor all endoscopes can be lengthy, especially for our proprietary endoscopes,due primarily to the commitment that customers must make to use our proprietaryEndoSheath.  We expect sales to thismarket will improve, compared to the fiscal year ended March 31, 2003, butthere is no assurance that such an improvement will occur.

 

The decrease in sales of theindustrial segment was due to continued lower demand for jet engine repairservices due to continued slowness in air travel.

 

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Gross Profit

 

Gross profit in Q1 04 increasedto $757,585, or 39% of net sales, compared to $461,973, or 27% of net sales inQ1 03.  Gross profit increased byapproximately $348,500 in the medical segment, and decreased by approximately$52,900 in the industrial segment.  Theincrease in gross profit in the medical segment was due primarily to the lowerunit costs of the ENT EndoSheath, resulting from full implementation of our newmanufacturing equipment.  In addition,the higher volume of ENT EndoSheath units sold and the higher prices attainedfor GI EndoSheaths added to the increase in gross profit.  In the industrial segment, the decrease ingross profit was due primarily to lower sales volume and product mix.

 

In order to further reduce ourproduction costs, we recently entered into a contract manufacturing agreementwith 3BY, providing for the transfer of the production of our GI and pulmonaryEndoSheaths to 3BY.  In addition, wehave agreed to lend 3BY up to $267,500 to purchase and install a line of equipmentthat will allow 3BY to manufacture our ENT EndoSheaths.  We will then have the ability to manufactureENT EndoSheaths in both Natick, MA and Israel. The purpose of this transfer of manufacturing is to lower our productioncosts.  As of June 30, 2003, we haveadvanced approximately $70,000 of the loan amount to 3BY.  According to the 3BY Agreements, we willestablish a repayment schedule once the production line is operational.  Until that time, 3BY has agreed to provideus a security interest in the equipment to be purchased, or in other equipmentof equal value.  We expect shipments ofGI and pulmonary EndoSheaths from 3BY will begin in December 2003 and January2004, respectively.  We expect shipmentsof ENT EndoSheaths from 3BY will begin in February 2004.  As a result of the 3BY Agreements, we expectthat the per unit production costs of our EndoSheaths will decrease byapproximately 50%, thereby increasing our gross profit.

 

The Medtronic Agreement isexpected to result in an increase in unit sales of our ENT EndoSheaths and ENTendoscopes, the gross profit benefits of which will be offset by the lower unitsales prices to Medtronic Xomed, compared to our current sales prices to endusers.  Additional benefits of theMedtronic Agreement include the elimination of the commission expense wecurrently pay to our independent sales representatives for sales of ENTproducts, and the potential reduction of other marketing and sales expenses.

 

We expect to experience thefull effects of the Medtronic Agreement and the 3BY Agreements on our sales andgross profits in our fiscal year beginning April 1, 2003.

 

Operating Expenses

 

*Selling, General and Administrative Expenses*

 

Selling, general andadministrative (“SG&A”) expenses in Q1 04 increased by $83,366, or 11%,compared to Q1 03.  SG&A expenses amountedto 44% and 45% of net sales in Q1 04 and Q1 03, respectively.  SG&A expenses increased in the medicalsegment by approximately $32,000, due primarily to higher costs for personneland consulting fees.  SG&A expensesdeclined in the industrial segment by approximately $24,000, due primarily tolower costs for personnel.  SG&Aexpenses increased by approximately $75,000 in the corporate segment dueprimarily to higher costs for personnel costs and professional fees.

 

17

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*Research and Development Expenses*

 

R&D expenses increased by$65,099 in Q1 04, compared to Q1 03, and were 8% of sales in Q1 04, compared to5% in Q1 03.  The primary causes forthis increase were higher costs for additional personnel hired to work ondeveloping new products, and outside services related to CMOS patentapplications.  We expect costs forR&D will continue to be higher in FY 04, compared to FY 03, as we increaseour efforts to develop new products utilizing the technology inherent in ourEndoSheaths.

 

On May 29, 2003 we signed aDevelopment, Supply and Distribution Agreement (“DSDA”) with EndoscopicTechnologies, Inc. (“ESTECH”), a company with certain proprietary technologiesrelating to methods for minimally-invasive cardiovascular surgery.  In the DSDA, we and ESTECH have agreed touse commercially reasonable and diligent efforts to complete the development ofcertain products being designed for minimally-invasive surgery, specificallyfor the treatment of coronary atrial fibrillation.  The total value of the product development component of the DSDAis approximately $90,000.  According tothe terms of the DSDA, as of June 30, 2003, we had invoiced $45,000 to ESTECH,and recorded that total amount in a deferred revenue account within accruedliabilities on the accompanying consolidated financial statements.  We plan to utilize percentage-completionaccounting to recognize revenue from this contract.  We expect to complete the product development stage of the DSDAin the fiscal quarter ending June 30, 2004.

 

*Stock-based Compensation Expenses*

 

Stock-based compensation costsincreased by $150,260, due primarily to an increase in the fair value ofnon-qualified options.  This cost iscomputed by determining the change in the fair value of stock options grantedto non-employees of the Company.  We usethe Black-Scholes method to calculate the fair value.  This method uses stock price volatility, the closing price of ourcommon stock as traded on the Nasdaq SmallCap Market and other factors todetermine the fair value of non-qualified options.  In addition, during the three months ended June 30, 2003, thecompensation committee of our board of directors authorized the issuance ofnon-qualified options to purchase 1,295,000 shares of common stock to certainof our employees.  These options werepriced below the fair market price of our common stock on the date ofgrant.  Accordingly, we will recognizecompensation expense totaling approximately $65,000 from June 2003 throughDecember 2007, the vesting period of these options.

 

The net loss per share for Q104 was $.01, compared to a net loss of $.01 per share for Q1 03.

 

OperatingIncome (Loss)

 

Operating income (loss) bysegment was as follows ($000’s):

 
| **Segment** |   | **Q1 04** |   | **Q1 03** |   | **Change** |   |
|-------------|--------|-----------|--------|-----------|--------|------------|--------|
| Medical     |   | $         | 24     |      | $      | (243       | )      | $ | 267 |   |
| Industrial  |   | (25       | )      | 5         |   | (30        | )      |
| Corporate   |   | (328      | )      | (88       | )      | (240       | )      |
| Total       |   | $         | (329   | )         | $      | (326       | )      | $ | (3 | ) |

 

18

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In the medical segment, theimproved gross profit was the primary driver for the improvement in operatingincome (loss).  This improved grossprofit was partially offset by higher costs for SG&A and increased R&Dexpenses.  In the industrial segment,the lower gross profit, partially offset by lower SG&A expenses was theprimary driver for the change.  In thecorporate segment, the higher costs for stock-based compensation fornon-qualified options to non-employees was the primary driver for the higherloss.  In addition, the corporatesegment incurred higher expenses for personnel costs, R&D and professionalfees.

 

Liquidity andCapital Resources

At June 30, 2003, our principalsource of liquidity was working capital of approximately $3.8 million,including $2.8 million in cash, cash equivalents and marketablesecurities.  At June 30, 2003, we hadacceptances payable to a bank totaling approximately $17,000.  We have pledged $125,000 to secure theacceptances payable.

 

We also have an agreement witha bank, which includes a revolving line of credit under which we may borrow upto $1,000,000, net of up to $250,000 of any outstanding letters of credit andbanker’s acceptances.  Borrowings underthis loan arrangement must be fully cash collateralized.  The agreement also stipulates that when weachieve positive cash flow, as defined in the agreement, we will be eligible tonegotiate changes to this loan arrangement that may include changing theborrowing base for revolving loans, and the release of the pledged cashcollateral.

 

Our cash and cash equivalentsdecreased by approximately $39,000 in the three months ended June 30, 2003, dueprimarily to cash used for operations of approximately $307,000 and cash usedfor investing activities of approximately $90,000.  These uses were offset by selling new shares to non-affiliatedinvestors for approximately $352,000 in a private placement in April 2003 andan increase in acceptances payable to a bank of approximately $7,000.  We expect our current balance of cash, cashequivalents and marketable securities is sufficient to fund our operations atleast for the next twelve months.

 

In connection with the 3BYAgreements, we have agreed to lend 3BY up to $267,500 to purchase and install aline of equipment that will allow 3BY to manufacture our ENT EndoSheaths.  As of June 30, 2003 we have advancedapproximately $70,000 of the loan amount to 3BY.  According to the 3BY Agreements, we will establish a repaymentschedule once the production line is operational.  Until that time, 3BY has agreed to provide us a security interestin the equipment to be purchased, or in other equipment of equal value.

 

We expect total spending forproperty and equipment will not exceed $500,000 for the fiscal year endingMarch 31, 2004.

 

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We conduct our operations in certainfacilities leased from non-related parties. These leases expire on various dates through October 31, 2006.  In addition, we have operating leases forcertain office equipment leased from non-related parties.  These leases expire on various dates throughMay 2006.  Approximate future minimumlease commitments under these leases are as follows:

 
| **Year ending March 31,** |   |    |    |
|---------------------------|--------|---------|---------|
| 2004                      |   | $       | 302,000 |   |
| 2005                      |   | 309,000 |    |
| 2006                      |   | 229,000 |    |
| 2007                      |   | 95,000  |    |
| Total                     |   | $       | 935,000 |   |

 

We have incurred losses sinceour inception, and losses are expected to continue at least during the fiscalyear ending March 31, 2004 (“FY 04”). We have funded the losses principally with the proceeds from public andprivate equity financings.  Although wedo not anticipate the need for additional financing in FY 04, management hasdecided that new financing may be desirable. However, there can be no assurance that additional funding will beavailable, or available on reasonable terms.

 

## **Item 3**.  QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKETRISK

 

In the normal course ofbusiness, we are subject to the risks associated with fluctuations in interestrates and changes in foreign currency exchange rates.

 

#### *Interestand Market Risk*

 

We maintain a portfolio ofmarketable, primarily fixed income, available-for-sale securities of variousissuers, types and maturities.  We havenot used derivative financial instruments in our investment portfolio.  We attempt to limit our exposure to interestrate and credit risk by placing our investments with high-quality financialinstitutions and have established investment guidelines relative todiversification and maturities designed to maintain safety and liquidity.

 

Investments in both fixed-rateand floating-rate interest earning instruments carry a degree of interest raterisk.  Fixed-rate securities may havetheir fair market value adversely impacted due to a rise in interest rates,while floating-rate securities may produce less income than expected ifinterest rates decline.  Due in part tothese factors, our future investment income may fall short of expectations dueto changes in interest rates, or we may suffer losses in principal if forced tosell securities which have seen a decline in market value due to changes ininterest rates.

 

#### *ForeignCurrency Exchange*

 

We face exposure, due topurchases of raw materials from Japanese suppliers, to adverse movements in thevalue of the Japanese Yen.  Thisexposure may change over time, and could have a materially adverse effect on ourfinancial results.  We may attempt tolimit this exposure by purchasing forward contracts, as required.  Most of our liabilities are settled within90 days of receipt of materials.  AtJune 30, 2003, our liabilities relating to Japanese Yen were approximately$49,000.

 

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## **Item 4**.  CONTROLS AND PROCEDURES

 

*a)**            Evaluation ofDisclosure Controls and Procedures.*

 

Based on an evaluation of ourdisclosure controls and procedures (as defined in Rules 13a-14(c) and 15d-14(c)under the Securities Exchange Act of 1934), the chief executive officer andchief financial officer have concluded that our disclosure controls andprocedures as of the end of the three months ended June 30, 2003, are designedto ensure that information required to be disclosed by us in the reports thatwe file or submit under the Exchange Act is recorded, processed, summarized andreported within the time periods specified in the SEC’s rules and forms and areoperating in an effective manner.

 

*b)**            Changes in InternalControls.*

 

There were no significantchanges in our internal controls or in other factors that could significantlyaffect these controls subsequent to the date of their most recent evaluation.

 

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**PART II****- OTHER INFORMATION**

 

**Item5****.  OtherInformation**

 

In June 2003, we entered into a Contract Manufacturing Agreement, aLoan Agreement and a Pledge Agreement with 3BY.  The information included in Note 4 to the unaudited, consolidatedfinancial statements furnished under Part I, Item 1 herein, and the informationincluded in Part I, Item 2 under the caption “Management’s Discussion andAnalysis of Financial Condition and Results of Operations” is herebyincorporated by reference.

 

On August 6, 2003, we entered into the Medtronic Agreement, which weexpect will become effective on or about September 17, 2003.  Under the Medtronic Agreement, we havegranted Medtronic Xomed exclusive rights to distribute our ENT EndoSheaths andENT endoscopes to ENT practitioners in the United States and Canada.  The information included in Part I, Item 2under the caption “Management’s Discussion and Analysis of Financial Conditionand Results of Operations” is hereby incorporated by reference.

 

**Item6****.  Exhibits andReports on Form 8-K**

 

(a)                                              Exhibits

10.1                           ContractManufacturing Agreement, dated June 25, 2003, by and between the Registrant andThree BY Ltd.

 

10.2                           LoanAgreement, dated June 25, 2003, by and between the Registrant and Three BY Ltd.

 

10.3                           PledgeAgreement, dated June 25, 2003, by and between the Registrant and Three BY Ltd.

 

31                                    Rule13a-14(c)/15d-14(c) Certifications

 

32                                    Certificationpursuant to 18 U.S.C. §1350

 

(b)                                             Reportson Form 8-K

None.

 

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##### **SIGNATURES**

 

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

 
|                   | VISION-SCIENCES,  INC.                                                                                                                 |
|------------------------|----------------------------------------------------------------------------------------------------------------------------------------|
|                   |                                                                                                                                   |
| Date: August  14, 2003 | /s/ Ron  Hadani                                                                                                                        |   |
|                   | Ron Hadani                                                                                                                             |
|                   | President, Chief  Executive Officer                                                                                                    |
|                   |                                                                                                                                   |
|                   |                                                                                                                                   |
| Date: August  14, 2003 | /s/ James A.  Tracy                                                                                                                    |   |
|                   | James A.  Tracy                                                                                                                        |
|                   | Vice  President Finance, Chief Financial Officer and  Controller (Principal Financial Officer and Principal  Accounting  Officer) |
|                        |                                                                                                                                        |  |  |  |

 

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