**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D. C.20459**

 

**FORM 10-Q**

 

| **QUARTERLY  REPORT UNDER SECTION 13 OR 15(d)  OF THE SECURITIES EXCHANGE ACT OF 1934** |
|-----------------------------------------------------------------------------------------|
|                                                                                    |   |   |
| **FOR THE QUARTER ENDED December 31, 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 filing requirementfor the past 90 days.

 

Yes  ý        No  o

 

Indicate by check mark whether the registrantis an accelerated filer (as defined in Rule 12b-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 December 31, 2003.

 

| **Common Stock, par value of $.01** |   | **30,243,028**     |
|-------------------------------------|--------|--------------------|
| (Title of Class)                    |   | (Number of Shares) |

 

 

----

 

**VISION-SCIENCES, INC.**

**TABLE OF CONTENTS**

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

 

2

----

 

**PART I - FINANCIAL INFORMATION**

**Item 1: FINANCIAL STATEMENTS**

 

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

**CONSOLIDATED BALANCE SHEETS**

**(Unaudited)**

 
|                                                                                                                                                                               |   | **December 31,  2003** |      | **March 31,  2003** |   |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------|-----------|---------------------|--------|
| ASSETS                                                                                                                                                                             |   |                   |      |                |   |
|                                                                                                                                                                               |   |                   |      |                |   |
| Current Assets:                                                                                                                                                                    |   |                   |      |                |   |
| Cash and cash equivalents                                                                                                                                                          |   | $                      | 2,236,965 |                | $      | 2,744,143 |   |
| Marketable securities                                                                                                                                                              |   | 125,371                |      | 125,072             |   |
| Accounts receivable, net of allowance for  doubtful accounts of $71,567 and $77,185, respectively                                                                                  |   | 1,249,759              |      | 736,711             |   |
| Inventories                                                                                                                                                                        |   | 1,294,412              |      | 1,160,372           |   |
| Prepaid expenses and deposits                                                                                                                                                      |   | 86,144                 |      | 51,113              |   |
| Total current assets                                                                                                                                                               |   | 4,992,651              |      | 4,817,411           |   |
|                                                                                                                                                                               |   |                   |      |                |   |
| Property and Equipment, at cost:                                                                                                                                                   |   |                   |      |                |   |
| Machinery and equipment                                                                                                                                                            |   | 3,504,346              |      | 3,393,099           |   |
| Furniture and fixtures                                                                                                                                                             |   | 212,002                |      | 208,934             |   |
| Leasehold improvements                                                                                                                                                             |   | 473,411                |      | 467,620             |   |
|                                                                                                                                                                               |   | 4,189,759              |      | 4,069,653           |   |
| Less-Accumulated depreciation and  amortization                                                                                                                                    |   | 3,681,531              |      | 3,529,977           |   |
|                                                                                                                                                                               |   | 508,228                |      | 539,676             |   |
|                                                                                                                                                                               |   |                   |      |                |   |
| Advance to Three BY Ltd                                                                                                                                                            |   | 267,500                |      | —              |   |
|                                                                                                                                                                               |   |                   |      |                |   |
| Other assets, net of accumulated  amortization of $45,844 and $41,087, respectively                                                                                                |   | 68,336                 |      | 89,759              |   |
| Total assets                                                                                                                                                                       |   | $                      | 5,836,715 |                | $      | 5,446,846 |   |
|                                                                                                                                                                               |   |                   |      |                |   |
| LIABILITIES  AND STOCKHOLDERS’ EQUITY                                                                                                                                         |   |                   |      |                |   |
|                                                                                                                                                                               |   |                   |      |                |   |
| Current Liabilities:                                                                                                                                                               |   |                   |      |                |   |
| Acceptances payable to a bank                                                                                                                                                      |   | $                      | 89,642    |                | $      | 10,621 |   |
| Accounts payable                                                                                                                                                                   |   | 685,598                |      | 294,312             |   |
| Accrued expenses                                                                                                                                                                   |   | 869,325                |      | 804,139             |   |
| Total current liabilities                                                                                                                                                          |   | 1,644,565              |      | 1,109,072           |   |
|                                                                                                                                                                               |   |                   |      |                |   |
| Potential obligations to non-qualified  option holders                                                                                                                             |   | 690,917                |      | 201,648             |   |
|                                                                                                                                                                               |   |                   |      |                |   |
| Stockholders’ Equity:                                                                                                                                                         |   |                   |      |                |   |
| Common stock, $.01 par value—  Authorized—50,000,000 shares  Issued and outstanding—30,243,028 shares at December 31, 2003 and 29,588,280  shares at March 31, 2003 |   | 302,429                |      | 295,882             |   |
| Additional paid-in capital                                                                                                                                                         |   | 60,570,290             |      | 60,082,930          |   |
| Accumulated deficit                                                                                                                                                                |   | (57,371,486            | )         | (56,242,686         | )      |
| Total stockholders’ equity                                                                                                                                                    |   | 3,501,233              |      | 4,136,126           |   |
| Total liabilities and stockholders’ equity                                                                                                                                    |   | $                      | 5,836,715 |                | $      | 5,446,846 |   |

 

See accompanying notes to consolidated financial statements.

 

3

----

 

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

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

**(Unaudited)**

 
|                                                                           |   | **Three  Months Ended  December 31,** |      | **Nine  Months Ended  December 31,** |   |
|--------------------------------------------------------------------------------|--------|---------------------------------------|-----------|--------------------------------------|--------|
|                                                                           |   | **2003**                              |      | **2002**                             |   | **2003** |   | **2002** |   |
|                                                                           |   |                                  |      |                                 |   |   |   |   |   |
| Net sales                                                                      |   | $                                     | 2,717,775 |                                 | $      | 1,636,788 |   | $ | 6,785,012 |   | $ | 4,883,371 |   |
| Cost of sales                                                                  |   | 1,826,106                             |      | 1,289,857                            |   | 4,333,773 |   | 3,654,020 |   |
|                                                                           |   |                                  |      |                                 |   |   |   |   |   |
| Gross profit                                                                   |   | 891,669                               |      | 346,931                              |   | 2,451,239 |   | 1,229,351 |   |
|                                                                           |   |                                  |      |                                 |   |   |   |   |   |
| Selling, general and administrative  expenses (1)                              |   | 847,537                               |      | 766,308                              |   | 2,655,289 |   | 2,349,463 |   |
| Research and development expenses (1)                                          |   | 159,452                               |      | 128,897                              |   | 454,785 |   | 319,359 |   |
| Stock-based compensation                                                       |   | (132,531                              | )         | (10,070                              | )      | 502,457 |   | (196,153 | ) |
| Income (loss) from operations                                                  |   | 17,211                                |      | (538,204                             | )      | (1,161,292 | ) | (1,243,318 | ) |
|                                                                           |   |                                  |      |                                 |   |   |   |   |   |
| Interest income                                                                |   | 6,681                                 |      | 8,944                                |   | 21,393 |   | 33,178 |   |
| Interest expense                                                               |   | —                                |      | —                               |   | — |   | (724 | ) |
| Other income, net                                                              |   | 3,862                                 |      | 3,366                                |   | 11,099 |   | 13,921 |   |
|                                                                           |   |                                  |      |                                 |   |   |   |   |   |
| Net income (loss)                                                              |   | $                                     | 27,754    |                                 | $      | (525,894 | ) | $ | (1,128,800 | ) | $ | (1,196,943 | ) |
|                                                                           |   |                                  |      |                                 |   |   |   |   |   |
| Basic and diluted net income (loss) per common  share                          |   | $                                     | 0.00      |                                 | $      | (0.02 | )  | $ | (0.04 | ) | $ | (0.04 | )  |
|                                                                           |   |                                  |      |                                 |   |   |   |   |   |
| Shares used in computing basic and diluted  net income (loss) per common share |   | 30,228,794                            |      | 27,198,712                           |   | 30,118,564 |   | 27,194,454 |   |

 

----

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

 
| Research and development expenses             |   | $       | (121,114 | )   | $ | (10,054 | )      | $      | 398,449 |   | $ | (268,526 | ) |
|-----------------------------------------------|--------|---------|----------|-----|---|---------|--------|--------|---------|--------|---|----------|---|
| Selling, general and administrative  expenses |   | (11,417 | )        | (16 | ) | 104,008 |   | 72,373 |    |
| Total                                         |   | $       | (132,531 | )   | $ | (10,070 | )      | $      | 502,457 |   | $ | (196,153 | ) |

 

See accompanying notes to consolidated financial statements.

 

4

----

 

**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, net                                             |   | 524,098              |   | 5,241                           |    | 323,771                  |   | —                                |   | 329,012                       |        |   |   |
| Compensation expense related to employee  non-qualified stock options |   |                 |   |                            |    | 13,188                   |   | —                                |   | 13,188                        |        |   |   |
| Exercise of incentive stock options                                   |   | 130,650              |   | 1,306                           |    | 150,401                  |   |                                  |   | 151,707                       |        |   |   |
| Net loss                                                              |   | —               |   | —                          |    | —                   |   | (1,128,800                            | )      | (1,128,800                    | )           | $ | (1,128,800 | ) |
| Total comprehensive loss                                              |   |                 |   |                            |    |                     |   |                                  |   |                          |        | $ | (1,128,800 | ) |
|                                                                  |   |                 |   |                            |    |                     |   |                                  |   |                          |        |   |   |
| Balance December 31, 2003                                             |   | 30,243,028           |   | $                               | 302,429 |                     | $      | 60,570,290                            |   | $                             | (57,371,486 | ) | $ | 3,501,233 |   |   |   |

 

See accompanying notes to consolidated financial statements.

 

5

----

 

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

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(Unaudited)**

 
|                                                                                              |   | **Nine  Months Ended  December 31, 2003** |       | **Nine  Months Ended  December 31, 2002** |   |
|---------------------------------------------------------------------------------------------------|--------|-------------------------------------------|------------|-------------------------------------------|--------|
| Cash flows from operating activities:                                                             |   |                                      |       |                                      |   |
| Net loss                                                                                          |   | $                                         | (1,128,800 | )                                         | $      | (1,196,943 | ) |
| Adjustments to reconcile net loss to net  cash used for operating activities:                     |   |                                      |       |                                      |   |
| Depreciation and amortization                                                                     |   | 156,311                                   |       | 165,297                                   |   |
| Stock compensation for non-qualified options                                                      |   | 502,457                                   |       | (196,153                                  | )      |
| Changes in assets and liabilities:                                                                |   |                                      |       |                                      |   |
| Accounts receivable                                                                               |   | (513,048                                  | )          | 171,708                                   |   |
| Inventories                                                                                       |   | (134,040                                  | )          | (83,189                                   | )      |
| Prepaid expenses and deposits                                                                     |   | (35,031                                   | )          | (18,215                                   | )      |
| Accounts payable                                                                                  |   | 391,286                                   |       | 63,958                                    |   |
| Accrued expenses                                                                                  |   | 65,186                                    |       | (200,198                                  | )      |
|                                                                                              |   |                                      |       |                                      |   |
| Net cash used for operating activities                                                            |   | (695,679                                  | )          | (1,293,735                                | )      |
|                                                                                              |   |                                      |       |                                      |   |
| Cash flows used for investing activities                                                          |   |                                      |       |                                      |   |
| Increase in marketable securities                                                                 |   | (299                                      | )          | (885,335                                  | )      |
| Purchase of property and equipment, net                                                           |   | (120,106                                  | )          | (105,760                                  | )      |
| Advances to Three BY Ltd                                                                          |   | (267,500                                  | )          | —                                    |   |
| Other assets                                                                                      |   | 16,666                                    |       | —                                    |   |
|                                                                                              |   |                                      |       |                                      |   |
| Net cash used for investing activities                                                            |   | (371,239                                  | )          | (991,095                                  | )      |
|                                                                                              |   |                                      |       |                                      |   |
| Cash flows provided by (used for) financing  activities:                                          |   |                                      |       |                                      |   |
| Payments on note payable for leasehold  improvements                                              |   | —                                    |       | (23,989                                   | )      |
| Proceeds from acceptances payable to a bank                                                       |   | 79,021                                    |       | (23,671                                   | )      |
| Proceeds from the sale of common stock, net                                                       |   | 329,012                                   |       | —                                    |   |
| Exercise of stock options                                                                         |   | 151,707                                   |       | 20,500                                    |   |
| Net cash provided by (used for) financing  activities                                             |   | 559,740                                   |       | (27,160                                   | )      |
|                                                                                              |   |                                      |       |                                      |   |
| Net decrease in cash and cash equivalents                                                         |   | (507,178                                  | )          | (2,311,990                                | )      |
| Cash and cash equivalents, beginning of  period                                                   |   | 2,744,143                                 |       | 2,890,364                                 |   |
| Cash and cash equivalents, end of period                                                          |   | $                                         | 2,236,965  |                                      | $      | 578,374 |   |
|                                                                                              |   |                                      |       |                                      |   |
| Supplemental Disclosure of Cash Flow  Information:                                                |   |                                      |       |                                      |   |
| Cash paid during the period for interest                                                          |   | $                                         | —     |                                      | $      | 724 |   |
|                                                                                              |   |                                      |       |                                      |   |
| 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 |   | $                                         | 489,269    |                                      | $      | (276,008 | ) |

 

See accompanying notes to consolidated financial statements.

 

6

----

 

**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.  AtDecember 31, 2003, the Company’s marketable securities consisted of acertificate of deposit with a weighted average 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:

 
|            |   | **December  31,  2003** |            | **March 31,  2003** |   |
|-----------------|--------|-------------------------|-----------------|---------------------|--------|
|            |   |                    |            | **(audited)**       |   |
|            |   |                    |            |                |   |
| Raw materials   |   | $                       | 751,220         |                | $      | 567,008 |   |
| Work-in-process |   | 171,921                 |            | 155,723             |   |
| Finished goods  |   | 371,271                 |            | 437,641             |   |
|            |   | $                       |  1,294,412 |                | $      |  1,160,372 |   |

 

Work-in-processand finished goods inventories consist of material, labor, and manufacturingoverhead.

 

7

----

 

 

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 been considered, to theextent their effect would be dilutive.

 

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 financialstatement and income tax bases of assets and liabilities as measured by theenacted tax rates.

 

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

 

8

----

 

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 December 31, 2003 to purchase 1,463,032 shares of theCompany’s common stock should be designated as a liability.

 

The Companyvalued the non-qualified options outstanding to non-employees at December 31,2003 and 2002 using the Black-Scholes method. The value of those options decreased by $138,183 and by $10,070 in thethree months ended December 31, 2003 and 2002, respectively.  The Company recorded the 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 (“APB”) 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 purchase1,295,000 shares of common stock to its employees at an exercise price of $1.04per share.  The fair market value of thecommon stock on the date of grant was $1.09 per share.  As a result, the Company will recognizecompensation expense for the difference between the fair market value and theoption price over the life of the options. In the three and nine months ended December 31, 2003, the Companyrecognized $5,652 and $13,188, respectively of expense as stock-basedcompensation in the consolidated statement of operations.

 

9

----

 

Had compensation expense for all stock option grantsto employees been determined under the fair value method at the grant dates,consistent with the method prescribed by SFAS No. 123, the Company’s net losswould have changed to the pro forma amounts indicated as follows:

 
|                                                  |   | **Three Months Ended  December 31** |    | **Nine Months Ended  December 31** |   |
|-------------------------------------------------------|--------|-------------------------------------|---------|------------------------------------|--------|
|                                                  |   | **2003**                            |    | **2002**                           |   | **2003** |   | **2002** |   |
| Net income (loss) – as  reported                 |   | $                                   | 27,754  |                               | $      | (525,894 | ) | $ | (1,128,800 | ) | $ | (1,196,943 | ) |
| Stock-based employee  compensation – as reported |   | 5,652                               |    | —                             |   | 13,188 |   | — |   |
| Pro forma stock-based  employee compensation          |   | (69,000                             | )       | (86,300                            | )      | (207,000 | ) | (258,900 | ) |
| Net loss – pro forma                             |   | $                                   | (35,594 | )                                  | $      | (612,194 | ) | $ | (1,322,612 | ) | $ | (1,455,843 | ) |
|                                                  |   |                                |    |                               |   |   |   |   |   |
| Net income (loss) per  share – as reported       |   | $                                   | —  |                               | $      | (.02 | ) | $ | (.04 | ) | $ | (.04 | ) |
| Stock-based employee  compensation – as reported |   | —                              |    | —                             |   | — |   | — |   |
| Pro forma stock-based  employee compensation          |   | —                              |    | —                             |   | — |   | (.01 | ) |
| Net loss per share -  pro forma                       |   | $                                   | —  |                               | $      | (.02 | ) | $ | (.04 | ) | $ | (.05 | ) |

 

*l.**                                         RecentlyIssued Accounting Standards*

 

In May 2003, theFinancial Accounting Standards Board (“FASB”) issued SFAS No. 150, *Accountingfor Certain Financial Instruments with Characteristics of Both Liabilities andEquity*.  SFAS No. 150 is thefirst phase of the FASB’s project on liabilities and equity.  SFAS No. 150 provides guidance on how anentity classifies and measures certain financial instruments withcharacteristics of both liabilities and equity.  Many of these instruments were previously classified asequity.  For example, if an employer’sissuance of its shares to a key employee requires the employer to redeem theshares upon the employee’s death, then those shares must be classified as aliability, not as equity.  Forpublicly-held companies, SFAS No. 150 is effective for financial instrumentsentered into or modified after May 31, 2003. SFAS No. 150 requires companies to record the cumulative effect offinancial instruments existing at the adoption date.  The adoption of SFAS 150 has not had a significant effect on theCompany’s operations, financial position or cash flows.

 

10

----

 

In November 2002, theEITF reached consensus on EITF No. 00-21, *Revenue Arrangements with Multiple Deliverables*.  Revenue arrangements with multipledeliverables include arrangements that provide for the delivery or performanceof multiple products, services and/or rights to use assets where performancemay occur at different points in time or over different periods of time.  The Company may enter into arrangements formultiple deliverables that occur at different points in time if it enters intoa contract to sell endoscopes and EndoSheaths on a per-procedure basis.  EITF No. 00-21 was effective for the Companybeginning July 1, 2003.  The adoption ofEITF No. 00-21 has not had a significant effect on the Company’s operations,financial position or cash flows.

 

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

 

The Company accounts for its investment in 3DV SystemsLtd. (“3DV”) using the equity method of accounting.  As of December 31, 2003, the Company owned approximately 21% ofthe outstanding shares of 3DV, and would hold approximately 17% of the sharesof 3DV, if all employee options and Convertible Notes were converted to commonshares.  The Company’s investment in 3DVtotaled $0 at March 31, 2003, and accordingly, the Company did not recognizeany portion of the losses of 3DV for the three or nine months ended December31, 2003.

 

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

 

In June 2003, the Company entered into a ContractManufacturing Agreement, a Loan Agreement and a Pledge Agreement (collectively,the “3BY Agreements”) with Three BY Ltd., an Israeli company (“3BY”).  The 3BY Agreements provide for, among otherthings, the manufacture of certain of the Company’s products by 3BY, and a loanof up to $267,500 by the Company to 3BY for the purchase and installation ofcertain manufacturing equipment by 3BY, at 3BY’s facility, to be used tomanufacture certain of the Company’s products. As of December 31, 2003, the Company had advanced $267,500 to 3BY.  After production has begun, the Company and3BY plan to establish a repayment schedule, according to the 3BY Agreements.

 

11

----

 

**5.****                                      SegmentInformation**

 

The Company has three reportable segments – medical,industrial and corporate.  The medicalsegment designs, manufactures and sells EndoSheaths and sells endoscopes tousers in the health care industry.  Theindustrial segment designs, manufactures and sells borescopes to a variety ofusers, primarily in the aircraft engine manufacturing and aircraft enginemaintenance industries.  In addition,the industrial segment manufactures and repairs endoscopes for the medicalsegment.  The corporate segment consistsof certain administrative expenses applicable to the Company as a whole and themanagement oversight of the Company’s investment in 3DV, Vision-Sciences Ltd.(the Company’s Israeli subsidiary) and the Company’s support of the Universityof Georgia 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 December 31, 2003was $0.  Data regarding management’sview of the Company’s segments are provided in the following tables.

 

12

----

 
|                                  |   | **Medical** |      | **Industrial** |   | **Corporate** |   | **Adjustments** |   | **Total**  |   |
|---------------------------------------|--------|-------------|-----------|----------------|--------|---------------|--------|-----------------|--------|------------|--------|
| Three months ended  December 31, |   |        |      |           |   |          |   |            |   |       |   |
| **2003**                              |   |        |      |           |   |          |   |            |   |       |   |
| Sales to external customers           |   | $           | 1,767,982 |           | $      | 949,793       |   | $               | — |       | $      | — |   | $ | 2,717,775 |   |
| Intersegment sales                    |   | —      |      | 612,914        |   | —        |   | (612,914        | )      | —     |   |
| Operating income (loss)               |   | 66,906      |      | 102,102        |   | (151,797      | )      | —          |   | 17,211     |   |
| Interest income (expense)             |   | —      |      | —         |   | 6,681         |   | —          |   | 6,681      |   |
| Depreciation and amortization         |   | 38,401      |      | 10,083         |   | —        |   | —          |   | 48,484     |   |
| Advance to 3BY Ltd.                   |   | 51,000      |      | —         |   | —        |   | —          |   | 51,000     |   |
| Other significant non-cash items:     |   |        |      |           |   |          |   |            |   |       |   |
| Stock-based compensation              |   | 321         |      | 107            |   | (132,959      | )      | —          |   | (132,531   | )      |
| Expenditures for fixed assets         |   | 69,474      |      | —         |   | —        |   | —          |   | 69,474     |   |
|                                  |   |        |      |           |   |          |   |            |   |       |   |
| **2002**                              |   |        |      |           |   |          |   |            |   |       |   |
| Sales to external customers           |   | $           | 970,219   |           | $      | 666,569       |   | $               | — |       | $      | — |   | $ | 1,636,788 |   |
| Intersegment sales                    |   | —      |      | 158,784        |   | —        |   | (158,784        | )      | —     |   |
| Operating income (loss)               |   | (302,818    | )         | (66,777        | )      | (168,609      | )      | —          |   | (538,204   | )      |
| Interest income (expense)             |   | —      |      | —         |   | 8,944         |   | —          |   | 8,944      |   |
| Depreciation and amortization         |   | 46,507      |      | 10,708         |   | —        |   | —          |   | 57,215     |   |
| Other significant non-cash items:     |   |        |      |           |   |          |   |            |   |       |   |
| Stock-based compensation              |   | —      |      | —         |   | (10,070       | )      | —          |   | (10,070    | )      |
| Expenditures for fixed assets         |   | 17,473      |      | 232            |   | —        |   | —          |   | 17,705     |   |
|                                  |   |        |      |           |   |          |   |            |   |       |   |
| Nine months ended December 31,   |   |        |      |           |   |          |   |            |   |       |   |
| **2003**                              |   |        |      |           |   |          |   |            |   |       |   |
| Sales to external customers           |   | $           | 4,438,597 |           | $      | 2,346,415     |   | $               | — |       | $      | — |   | $ | 6,785,012 |   |
| Intersegment sales                    |   | —      |      | 1,169,131      |   | —        |   | (1,169,131      | )      | —     |   |
| Operating income (loss)               |   | 107,581     |      | 81,332         |   | (1,350,205    | )      | —          |   | (1,161,292 | )      |
| Interest income (expense)             |   | —      |      | —         |   | 21,393        |   | —          |   | 21,393     |   |
| Depreciation and amortization         |   | 126,209     |      | 30,102         |   | —        |   | —          |   | 156,311    |   |
| Advance to 3BY Ltd.                   |   | 267,500     |      | —         |   | —        |   | —          |   | 267,500    |   |
| Other significant non-cash items:     |   |        |      |           |   |          |   |            |   |       |   |
| Stock-based compensation              |   | 750         |      | 250            |   | 501,457       |   | —          |   | 502,457    |   |
| Expenditures for fixed assets         |   | 118,594     |      | 1,512          |   | —        |   | —          |   | 120,106    |   |
| Total assets                          |   | 2,207,624   |      | 1,263,363      |   | 2,454,310     |   | (88,582         | )      | 5,836,715  |   |
|                                  |   |        |      |           |   |          |   |            |   |       |   |
| **2002**                              |   |        |      |           |   |          |   |            |   |       |   |
| Sales to external customers           |   | $           | 2,826,250 |           | $      | 2,057,121     |   | $               | — |       | $      | — |   | $ | 4,883,371 |   |
| Intersegment sales                    |   | —      |      | 512,698        |   | —        |   | (512,698        | )      | —     |   |
| Operating income (loss)               |   | (814,180    | )         | (76,806        | )      | (352,332      | )      | —          |   | (1,243,318 | )      |
| Interest income (expense)             |   | —      |      | (724           | )      | 33,178        |   | —          |   | 32,454     |   |
| Depreciation and amortization         |   | 136,527     |      | 28,770         |   | —        |   | —          |   | 165,297    |   |
| Other significant non-cash items:     |   |        |      |           |   |          |   |            |   |       |   |
| Stock-based compensation              |   | —      |      | —         |   | (196,153      | )      | —          |   | (196,153   | )      |
| Expenditures for fixed assets         |   | 75,333      |      | 30,427         |   | —        |   | —          |   | 105,760    |   |
| Total assets                          |   | 1,779,393   |      | 1,111,780      |   | 1,807,128     |   | (254,623        | )      | 4,443,678  |   |

 

13

----

 

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

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

 

Executive Summary

 

This Quarterly Report onForm 10-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 salesof new and existing products, future expenditures, and capital resources tomeet anticipated 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 and sell flexible endoscope products for themedical device and industrial device markets. We operate in three reporting segments, medical, industrial andcorporate.

 

#### *Medical Segment*

 

The medical segment supplies endoscopes and disposable EndoSheath®Systems (“EndoSheaths”) to the Ear-Nose-Throat (“ENT”), gastrointestinal (“GI”)and pulmonary markets.  Health-careproviders use EndoSheaths to cover the insertion tube of flexible endoscopes,such as ENT endoscopes, Trans-Nasal Esophagoscopes (“TNE”), sigmoidoscopes andbronchoscopes.  The EndoSheaths allowthe health-care providers to process patients economically by permitting theproviders to avoid reprocessing the endoscopes after each use.  In addition, the EndoSheaths ensure asterile insertion tube for each patient procedure.

 

Our strategy in the medical segment in FY 04 has evolved into threecomponents: a) improve sales distribution, b) lower manufacturing costs and c)increase the number of new product offerings.

 

#### *SalesDistribution*

 

Since September 19, 2003 we have been distributing all of ourproducts for the ENT markets in the U.S.A. and Canada through Medtronic Xomed,Inc. (“Medtronic Xomed”) as part of our exclusive distribution agreement (the“Medtronic Agreement”) with them. The initial term of the Medtronic Agreementis three years.  Thereafter, theMedtronic Agreement will be automatically renewed for successive one-yearperiods, unless terminated by either party upon advance written notice.  Under the Medtronic Agreement, we havegranted Medtronic Xomed exclusive distribution rights in the United States andCanada to market and sell our ENT EndoSheaths and ENT endoscopes to ENTpractitioners.  Medtronic Xomed hasagreed to certain minimum purchase requirements for the initial twelve-monthperiod of the term.  We expect theMedtronic Agreement will result in an increase in sales of our ENT EndoSheathsand ENT endoscopes due to the significantly greater marketing and salescapabilities of Medtronic Xomed.  Inaddition, the Medtronic Agreement is expected to facilitate the introduction ofnew products to the ENT market, such as the endoscope and EndoSheath for the

 

14

----

 

TNE procedure, by allowing quicker market acceptance of theseproducts.  As a result of the MedtronicAgreement, the success of our ENT product lines will be substantially dependentupon the success of the marketing and sales activities of Medtronic Xomed overwhich we have limited control.  We haveretained our domestic network of independent sales representatives for the GIand Pulmonary product lines.  Also, wehave retained our own international network of distributors for all our medicalproduct lines.

 

#### *CostReduction*

 

In the fourth fiscal quarter of the year ended March 31, 2003 (“FY03”), we completed the installation of machinery used to manufacture ENTEndoSheaths in our Natick, Massachusetts facility.  We designed this machinery to lower the cost to manufacture theseitems by increasing the automation of the assembly process.  For the nine months ended December 31,2003, the operation of the machinery has resulted in a reduction of thestandard unit cost of ENT EndoSheaths of approximately 50%.  In the fiscal year ending March 31,2004 (“FY 04”) we decided we could reduce manufacturing costs further bysub-contracting the manufacture of our EndoSheaths for the GI, Pulmonary andENT markets to a company in Israel. That program continues, and we expect to begin to receive product in thefiscal year beginning in April 2004.

 

#### *NewProducts*

 

In calendar 2003 we have received clearance from the U.S. Food and DrugAdministration, (“FDA”) to market our ENT Channeled EndoSheath, our ENT SensoryEndoSheath and our TNE esophagoscope and EndoSheath System.  We designed the first two products to allowENT physicians to perform various procedures in their offices, as opposed tothe current practice of performing the procedures in a hospital setting.  Using our ENT Channeled EndoSheath or theENT Sensory EndoSheath, along with the physician’s conventional ENT endoscope,gives the ENT physician the ability to perform procedures in the office,instead of travelling to a hospital to utilize a special channeled ENTendoscope.  In addition, underreimbursement procedures of the Centers for Medicare & Medicaid Services,(“CMS”), a governmental agency under the U.S. Department of Health and HumanServices, the ENT physician will receive a higher reimbursement by performingthe procedures in their offices than they receive when they perform them in ahospital.  We designed the TNEesophagoscope and EndoSheath to give ENT physicians the ability to perform anew procedure, the diagnosis of gastroesophageal reflux disease (“GERD”) intheir offices, using a local anesthetic. Currently gastroenterologists performthese procedures orally in endoscopy suites or hospitals using conscioussedation.  We intend to also market thisproduct to gastroenterologists, allowing them to perform a diagnostic procedurein their offices, where they will receive a higher reimbursement than theyreceive when performing the procedure in a hospital or endoscopy suite.

 

#### *Industrial Segment*

 

The industrial segment designs, manufactures and sells flexibleendoscopes, termed borescopes, for industrial users, and manufactures andrepairs flexible endoscopes for the medical segment.  The industrial segment users consist primarily of companies inthe aircraft engine manufacturing and maintenance markets and the defensemarket.

 

15

----

 

#### *Corporate Segment*

 

The corporate segment consists of certain administrative and businessdevelopment activities applicable to the company as a whole, and managementoversight of our investments in 3DV, Vision Sciences, Ltd. and the EgyptProject.

 

Critical AccountingPolicies and Estimates

 

This discussion and analysis of our financial condition and results ofoperations is based upon our Consolidated Financial Statements, which have beenprepared in accordance with accounting principles generally accepted in theUnited States.  See the Notes to theConsolidated Financial Statements included elsewhere herein.  Certain of our accounting policies requirethe application of judgment in selecting the appropriate assumptions forcalculating financial estimates.  Bytheir nature these judgments are subject to an inherent degree ofuncertainty.  We periodically evaluatethe judgments and estimates used for our critical accounting policies to ensurethat such judgments and estimates are reasonable for our interim and year-endreporting requirements.  These judgmentsand estimates 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:

 

### *RevenueRecognition*

 

We recognize revenue in accordance with SEC Staff Accounting BulletinNo. 101, *RevenueRecognition in Financial Statements*(SAB 101), as amended by SAB101A and 101B, and EITF 00-21.  Thesepronouncements require that five basic criteria must be met before revenue canbe recognized: (1) persuasive evidence that an arrangement exists; (2) deliveryhas occurred or services rendered; (3) the fee is fixed and determinable; (4)collectibility is reasonably assured and (5) the fair value of undeliveredelements, if any, exists.  Determinationof criterion (4) is based on management’s judgment regarding the collectibilityof invoices for products and services delivered to customers.  Determination of criterion (5) is based onmanagement’s judgment regarding the fair value of any undelivered elements of acontract.  Should changes in conditionscause management to determine these criteria are not met for certain futuretransactions, revenue recognized for any reporting period could be adverselyaffected.

 

# ***Potential Obligations to Non-qualified Option Holders***

 

Financial instruments, including derivatives and non-qualified optionsto purchase our common stock, require disclosure of an estimate of their fairvalues.  Fair values are based on listedmarket prices, where possible.  Weaccount for certain non-qualified options granted to non-employees to purchaseour common stock in accordance the EITF 00-19, *Accounting for Derivative FinancialInstruments Indexed to, and Potentially Settled in, a Company’s Own Stock*,and carry these contracts at fair value, with any changes in fair valuerecorded in the results of operations. Fair values for certain non-qualified optionsare derived from pricing models that consider current market and contractualprices for the underlying financial instruments or commodities, as well as timevalue and 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.

 

16

----

 

The Company uses the Black-Scholes method for determining the value ofthe potential obligation to non-qualified option holders.

 

We account for certain non-qualified options granted to employees topurchase our common stock in accordance with APB 25 and FIN 44.  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.

 

Results of Operations

 

Sales

*Q3 04 Compared to Q303*

 

Net sales for the threemonths ended December 31, 2003 (“Q3 04”) were $2,717,775, an increase of$1,080,987, or 66%, compared to the three-month period ended December 31,2002 (“Q3 03”).  During Q3 04, sales ofthe medical segment were $1,767,982, an increase of $797,763, or 82%, and salesof the industrial segment were $949,793, an increase of $283,224, or 42%,compared to Q3 03.  Medical segmentsales to the ENT market include sales of our own ENT endoscope, ENT EndoSheathsfor our ENT endoscope and for the ENT endoscopes of most other majormanufacturers, sales of our TNE endoscope and TNE EndoSheaths for thoseendoscopes.  Sales to the GI andpulmonary markets include sales of our proprietary endoscopes and EndoSheaths foruse with those endoscopes.  Sales termedOther include repairs of our endoscopes and accessories.  In the medical segment, the sales andchanges in sales by market were as follows ($000’s):

 
| **Market** |   | **Q3 04** |   | **Q3 03** |   | **Increase  (Decrease)** |   | **Percent** |   |
|------------|--------|-----------|--------|-----------|--------|--------------------------|--------|-------------|--------|
| ENT        |   | $         | 1,572  |      | $      | 758                      |   | $           | 814    |   | 107 | % |
| GI         |   | 120       |   | 132       |   | (12                      | )      | (9          | )%     |
| Pulmonary  |   | 21        |   | 24        |   | (3                       | )      | (13         | )%     |
| Other      |   | 55        |   | 56        |   | (1                       | )      | (2          | )%     |
| Total      |   | $         | 1,768  |      | $      | 970                      |   | $           | 798    |   | 82 | % |

 

#### *MedicalSegment – ENT Market*

 

Sales of ENT EndoSheaths in Q3 04 were approximately $720,000, anincrease of approximately $125,000, or 21%, compared to Q3 03.  Sales of ENT endoscopes were approximately$354,000, an increase of approximately $191,000, or 117%, compared to Q3 03.  Sales of TNE endoscopes and other ENTproducts, new in Q3 04, were approximately $498,000.  The U.S. Food and Drug Administration (“FDA”) granted usclearance to market our TNE Esophagoscope and EndoSheath System inAugust 2003.

 

17

----

 

Included in the sales of ENT EndoSheaths in Q3 04 are sales ofapproximately $393,000 to Medtronic Xomed for the domestic market, and $258,000to our international distributors.  Alsoincluded are sales of approximately $27,000 of our new ENT Channeled EndoSheathand ENT Sensory EndoSheath, and approximately $42,000 of our new TNEEndoSheath, compared to $0 for those items in Q3 03.  Sales of ENT EndoSheaths to the domestic market increased byapproximately $54,000, or 16%, due to higher unit volume of 53,866, compared to31,452 units in Q3 03.  The higher unitvolume was offset by lower unit prices to Medtronic Xomed.  Sales of ENT EndoSheaths to internationaldistributors increased by approximately $2,000 in Q3 04, compared to Q3 03, andunit sales increased to 44,355 from 44,230 in Q3 03.

 

The increase in sales ofENT endoscopes was due primarily to higher unit volume from the domesticmarket, partially offset by lower unit volume to the internationalmarkets.  Sales to domestic customerswere approximately $257,000, an increase of $211,000, or 449%, compared to Q303.  The increase in domestic sales wasdue primarily to the initial shipments of units to Medtronic Xomed.  Sales to international distributors wereapproximately $97,000, a decrease of $20,000, or 17%, compared to Q3 03.  In general, the sales cycle of endoscopes islonger and less predictable than the sales cycle of EndoSheaths.

 

We continue to promote our existing products to the internationalmarket, and we plan to introduce our new products to our internationaldistributors.  Further, we continue toseek new distributors who have a strong ENT presence in countries where we haveno representation.  Our business issubject to the typical risks associated with operating in internationalmarkets, including longer sales cycles, exposure to adverse changes in currencyexchange rates and compliance with local customs, rules and regulations.  There can be no assurance that our sales tointernational distributors will increase.

 

#### *MedicalSegment – GI and Pulmonary Markets*

#### * *

Sales to the GI (Gastrointestinal) and Pulmonary markets in Q3 04showed little change compared to Q3 03. We expect demand for these products will remain flat, or decline, due toreimbursement rates to health-care providers being insufficient to support theuse of our EndoSheaths for those procedures.

 

*Industrial Segment*

 

The increase in sales of the industrial segment was due to higherdemand for new equipment, offset slightly by lower demand for repair services.

 

18

----

 

*9 Months 04 Compared to 9 Months 03*

 

Net sales for the nine months ended December 31, 2003 (“9M 04”)were $6,785,012, an increase of $1,901,641, or 39%, compared to the nine-monthperiod ended December 31, 2002 (“9M 03”). During 9M 04, sales of the medical segment were $4,438,597, an increaseof $1,612,347, or 57%, compared to 9M 03. Sales of the industrial segment were $2,346,415, an increase of$289,294, or 14%, compared to 9M 03.  Inthe medical segment, the sales and changes in sales by market were as follows ($000’s):

 
| **Market** |   | **9M 04** |   | **9M 03** |   | **Increase  (Decrease)** |   | **Percent** |   |
|------------|--------|-----------|--------|-----------|--------|--------------------------|--------|-------------|--------|
| ENT        |   | $         | 3,804  |      | $      | 2,294                    |   | $           | 1,510  |   | 66 | % |
| GI         |   | 418       |   | 352       |   | 66                       |   | 19          | %      |
| Pulmonary  |   | 53        |   | 53        |   | —                   |   | —      | %      |
| Other      |   | 163       |   | 127       |   | 36                       |   | 28          | %      |
| Total      |   | $         | 4,438  |      | $      | 2,826                    |   | $           | 1,612  |   | 57 | % |

 

*Medical Segment – ENT Market*

 

Sales of ENT EndoSheathsin 9M 04 were approximately $2,445,000, an increase of $616,000, or 34%,compared to 9M 03.  In addition, salesof ENT endoscopes were approximately $861,000, an increase of approximately $396,000,or 85%, compared to 9M 03.  Sales of TNEendoscopes and other ENT products were approximately $498,000.  The sales of EndoSheaths include sales ofapproximately $42,000 of our new ENT Channeled EndoSheath and the ENT SensoryEndoSheath.

 

Sales of EndoSheaths in9M 04 to domestic customers were approximately $1,277,000, an increase of$214,000, or 20%, while sales of EndoSheaths to international distributors wereapproximately $1,084,000, an increase of $319,000, or 42%, compared to 9M03.  The unit volume of ENT EndoSheathsincreased by 43% to 329,755 in 9M 04 from 230,434 in 9M 03.  The unit volume to domestic customersincreased by 46%, to 144,020, while it increased by 41%, to 185,735, tointernational distributors.  The lowerpercentage increase in domestic dollar sales of EndoSheaths compared to theincrease in units is due primarily to the shipments of EndoSheaths to MedtronicXomed.  Although the average unit salesprice of EndoSheaths sold under the Medtronic Agreement is lower than theaverage unit sales price of EndoSheaths sold directly to domestic customers, weexpect that the increased unit sales will result in a total contribution margincomparable to the contribution margin in our FY 04 budget.  The average sales price of EndoSheaths soldto international distributors remained approximately the same for 9M 04,compared to 9M 03.

 

19

----

 

Sales of endoscopes in 9M04 to domestic customers, including Medtronic Xomed, were approximately$544,000, an increase of $261,000, or 92%, due primarily to a higher volume ofunits at average selling prices that were lower by approximately 13%, comparedto 9M 03.  Sales of endoscopes tointernational distributors were approximately $317,000, an increase of$135,000, or 74%, due primarily to higher unit volume, and higher averageselling price increase of approximately 2%.

 

*Medical Segment – GI and PulmonaryMarkets*

 

Sales to the GI andPulmonary markets have not grown significantly, due to reimbursement rates tohealth-care providers being insufficient to support the use of our EndoSheathsfor those procedures.  We expect thissituation will remain static, or decline, in the next twelve months.

 

*Industrial Market*

 

Sales to the industrial market were higher in 9M 04, compared to 9M 03,due primarily to growth in Q3 04. Although we believe it is too early to predict this growth willcontinue, we are optimistic that sales of this segment will return tohistorical levels of $3 to $3.5 million over the next twelve months.

 

Gross Profit

 

Gross profit in Q3 04 increased to $891,669, or 33% of net sales,compared to $346,931, or 21% of net sales in Q3 03.  Gross profit in the medical segment was approximately $616,000 anincrease of $420,100, compared to Q3 03. Gross profit in the industrial segment was approximately $276,000, anincrease of $124,600, compared to Q3 03. The increase in gross profit in the medical segment was due primarily tothe sale of TNE products and to the higher volume of ENT EndoSheaths.  These volume enhancements were partiallyoffset by a reduction in gross profit due to lower sales prices for ENTEndoSheaths to Medtronic Xomed.  Thisreduction due to lower prices was mitigated by the lower manufacturing costs wehave attained since the full implementation of our manufacturing equipment inNatick, Masachusetts.  In the industrialsegment, the increase in gross profit was due primarily to higher volumes, amore favorable product mix and higher absorption of manufacturing overhead.

 

Gross profit in 9M 04 increased to $2,451,239, or 36% of sales,compared to $1,229,351, or 25% of sales in 9M 03.  Gross profit in the medical segment was approximately $1,822,100,an increase of $1,143,400, compared to 9M 03. Gross profit in the industrial segment was approximately $629,100, anincrease of $78,500, compared to 9M 03. The increase in gross profit in the medical segment was due primarily tohigher volume of ENT EndoSheaths and to our lower unit manufacturing costs,partially offset by the lower prices in Q3 04, as stated above.  The increase in gross profit in theindustrial segment was due primarily to higher absorption of overhead due tothe increased volume of endoscopes manufactured for the medical segment.

 

20

----

 

In order to further reduce our production costs, in June 2003 weentered into a contract manufacturing agreement with 3BY, providing for thetransfer of the production of our GI and pulmonary EndoSheaths to 3BY.  In addition, we have agreed to lend 3BY upto $267,500 to purchase and install a line of equipment that will allow 3BY tomanufacture our ENT EndoSheaths.  Wewill then have the ability to manufacture ENT EndoSheaths in both Natick, MAand Israel.  The purpose of thistransfer of manufacturing is to lower our production costs and increase ourcapacity.  As of December 31, 2003,we have advanced $267,500 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 provided us with asecurity interest in equipment of equal value. We expect shipments of all products from 3BY will commence inApril 2004.  As a result of the 3BYAgreements, we expect that the per unit production costs of our EndoSheathswill decrease by approximately 50%, thereby increasing our gross profit.

 

The Medtronic Agreement is expected to result in an increase in unitsales of our ENT EndoSheaths and ENT endoscopes, the gross profit benefits ofwhich we expect will be offset by the lower unit sales prices to MedtronicXomed, compared to our sales prices to domestic end users.  Additional benefits of the MedtronicAgreement include the elimination of the commission expense we currently pay toour independent sales representatives for sales of ENT products, the potentialreduction of other marketing and sales expenses and the ability to obtain morerapid market acceptance of our new products in the ENT market.

 

We expect to experience the full effects of the Medtronic Agreement andthe 3BY Agreements on our sales and gross profits in our fiscal year beginningApril 1, 2004.

 

Operating Expenses

 

*Selling, General and Administrative Expenses*

 

Selling, general and administrative (“SG&A”) expenses in Q3 04increased by $81,229, or 11%, compared to Q3 03.  SG&A expenses decreased in the medical segment byapproximately $14,000, due primarily to lower costs for commissions to outsidesales representatives, as a result of the Medtronic Xomed Agreement.  SG&A expenses declined in the industrialsegment by approximately $44,000, due primarily to lower costs fordepreciation, personnel and facilities. SG&A expenses increased by approximately $139,000 in the corporatesegment due primarily to higher costs for our President and CEO, who started inFebruary 2003, accrued costs related to severance and higher fees forlegal and accounting services.

 

SG&A expensesincreased by $305,826, or 13%, in 9M 04, compared to 9M 03.  SG&A expenses increased in the medicalsegment by approximately $56,700, due primarily to higher expenses for legalfees related to patents.  SG&Adecreased in the industrial segment by approximately $79,700, and increased byapproximately $328,800 in the corporate segment due primarily to the samereasons as stated above.

 

21

----

 

*Research and Development Expenses*

 

R&D expenses were$159,452, an increase of $30,555, or 24%, in Q3 04, compared to Q3 03.  The primary causes for this increase werehigher costs for additional personnel hired to work on developing new productsfor the medical segment, offset by lower costs for outside services in thecorporate segment related to CMOS patent applications.  We expect costs for R&D will continue tobe higher in FY 04, compared to FY 03, as we increase our efforts to developnew products for cystoscopy, pediatric ENT, TNE therapeutic and Video EnabledEndoscopes.

 

R&D expenses were$454,785 in 9M 04, an increase of $135,426, or 42%, compared to 9M 03.  The primary causes for the increase werehigher costs for additional personnel hired to work on developing new productsfor the medical segment, as stated above.

 

On May 29, 2003 we signeda Development, 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 atrial fibrillation.  The DSDA provides for Estech to pay us $90,000 for the productdevelopment portion of this agreement. According to the terms of the DSDA, we have invoiced ESTECH $45,000related to this product development. This amount has been recorded as deferred revenue within accruedliabilities in 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 compensationcosts decreased by $122,461 in Q3 04, compared to Q3 03, due primarily to adecrease in the fair value of non-qualified options.  This non-cash cost is computed by determining the change in thefair value of stock options granted to non-employees of the Company.  We use the Black-Scholes method to calculatethe fair value.  This method uses stockprice volatility, the closing price of our common stock as traded on the NasdaqSmallCap Market and other factors to determine the fair value of non-qualifiedoptions.  The decrease in the closingprice of our common stock to $1.71 per share on the last trading day in the52-week period measured in Q3 04, from $1.86 per share for the comparableperiod measured in Q2 04, was the largest component in the change for the threemonths ended December 31, 2003.

 

In addition, during thethree months ended June 30, 2003, the compensation committee of our boardof directors authorized the issuance of non-qualified options to purchase1,295,000 shares of common stock to certain of our employees.  These options were priced below the fairmarket price of our common stock on the date of grant.  Accordingly, we will recognize compensationexpense totaling approximately $65,000 from June 2003 throughDecember 2007, the vesting period of these options.

 

Stock-based compensation costs increased by $698,610 in 9M 04, comparedto 9M 03, due primarily to the increase in the closing price of our commonstock each fiscal quarter, as discussed above.

 

22

----

 

The net income (loss) per share for Q3 04 was $0.00, compared to a($0.02) per share for Q3 03.  These pershare amounts are the same with or without the stock-based compensationcredits.

 

The net loss per share for 9M 04 was $.04, compared to $.04 in 9M 03.The net loss excluding the non-cash charge or credit for stock-based compensationcosts was $626,343, or $.02 per share in 9M 04, compared to $1,393,096, or $.05per share in 9M 03.

 

Operating Income (Loss)

 

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

 
| **Segment** |   | **Q3 04** |   | **Q3 03** |   | **Change** |   | **9M 04** |   | **9M 03** |   | **Change** |   |
|-------------|--------|-----------|--------|-----------|--------|------------|--------|-----------|--------|-----------|--------|------------|--------|
| Medical     |   | $         | 67     |      | $      | (303       | )      | $         | 370    |      | $      | 108        |   | $ | (814 | ) | $ | 922 |   |
| Industrial  |   | 102       |   | (67       | )      | 169        |   | 81        |   | (77       | )      | 158        |   |
| Corporate   |   | (152      | )      | (168      | )      | 16         |   | (1,350    | )      | (352      | )      | (998       | )      |
| Total       |   | $         | 17     |      | $      | (538       | )      | $         | 555    |      | $      | (1,161     | )      | $ | (1,243 | ) | $ | 82 |   |

 

For both the quarterly and nine-month periods above, in the medicalsegment, the improved gross profit was the primary driver for the improvementin operating income.  This improvedgross profit was partially offset by higher costs for SG&A and R&Dexpenses.  In the industrial segment,the higher gross profit and lower SG&A expenses were the primary driversfor the change.  In the corporatesegment, the higher costs for stock-based compensation for non-qualifiedoptions to non-employees was the primary driver for the higher loss.  In addition, the corporate segment incurredhigher expenses for personnel costs and professional fees.

 

Liquidity and Capital Resources

 

At December 31, 2003, our principal source ofliquidity was working capital of approximately $3.3 million, including$2.4 million in cash, cash equivalents and marketable securities.  At December 31, 2003, we hadacceptances payable to a bank totaling approximately $90,000.  We have pledged $125,000 to secure theacceptances payable, and as a security deposit to our landlord in Natick.  As we continue to manufacture moreendoscopes, we expect we will increase the amount pledged to cover a higherlevel of banker’s acceptances.  Weexpect the amount pledged will not exceed $200,000 by March 31, 2004.

 

We also have an agreement with a bank, which includesa revolving line of credit under which we may borrow up to $1,000,000, net ofup to $250,000 of any outstanding letters of credit and banker’sacceptances.  Borrowings under this loanarrangement must be fully cash collateralized. The agreement also stipulates that when we achieve positive cash flow,as defined in the agreement, we will be eligible to negotiate changes to thisloan arrangement that may include changing the borrowing base for revolvingloans, and the release of the pledged cash collateral.

 

23

----

 

Our cash and cashequivalents decreased by approximately $507,000 in the nine months endedDecember 31, 2003, due primarily to cash used for operations ofapproximately $696,000 and cash used for investing activities of approximately$371,000.  These uses were offset byselling new shares of our common stock to non-affiliated investors forapproximately $329,000, net, in a private placement in April 2003, cashgenerated by employee exercises of stock options of approximately $152,000 andan increase in acceptances payable to a bank of approximately $79,000.   Our burn rate for cash, cash equivalentsand marketable securities, excluding advances to 3BY, cash received from newequity and option exercises, was approximately $240,000 per quarter for 9M 04,reduced from approximately $482,000 per quarter for 9M 03.  We expect to generate cash by increasing oursales, as a result of the Medtronic Agreement. In addition, we plan to lower our costs by subcontracting themanufacture of EndoSheaths to 3BY.  Weexpect to increase our spending for research and development and S,G & Aexpenses, but not at the same rate as the improvements in sales and gross profitfrom the two actions mentioned above.  Asa result, we expect our current balance of cash, cash equivalents andmarketable securities is sufficient to fund our operations at least for thenext twelve months.

 

In connection with the3BY Agreements, we have agreed to lend 3BY up to $267,500 to purchase andinstall a line of equipment that will allow 3BY to manufacture our ENTEndoSheaths.  As of December 31,2003 we have advanced the entire $267,500 loan amount to 3BY.  According to the 3BY Agreements, we willestablish a repayment schedule once the production line isoperational.  Until that time, 3BY hasprovided us a security interest in equipment of equal value.

 

We expect total spending for property and equipment will not exceed$300,000 for the fiscal year ending March 31, 2004, excluding the advanceto 3BY.  In our fourth fiscal quarter,we expect to upgrade our computer systems. The total amount we expect to spend is less than $100,000, and we expectto pay for the equipment on a business lease over 48 months.

 

We conduct our operations in certain facilities leased from non-relatedparties.  These leases expire on variousdates through October 31, 2006.  Inaddition, we have operating leases for certain office equipment leased fromnon-related parties.  These leasesexpire on various dates through May 2006. Approximate future minimum lease commitments under these leases are asfollows:

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

 

We have incurred losses since our inception, and losses are expected tocontinue at least during FY 04.  We havefunded the losses principally with the proceeds from public and private equityfinancings.  Although we do notanticipate the need for additional financing in FY 04, management has decidedthat new financing may be desirable. However, there can be no assurance that additional funding will beavailable, or available on reasonable terms.

 

24

----

 

## **Item 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUTMARKET RISK**

 

In the normal course of business, we are subject to the risksassociated with fluctuations in interest rates and changes in foreign currencyexchange rates.

 

#### *Interest andMarket Risk*

 

We maintain a portfolioof marketable, 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-rate and floating-rate interest earninginstruments carry a degree of interest rate risk.  Fixed-rate securities may have their fair market value adverselyimpacted due to a rise in interest rates, while floating-rate securities mayproduce less income than expected if interest rates decline.  Due in part to these factors, our futureinvestment income may fall short of expectations due to changes in interestrates, or we may suffer losses in principal if forced to sell securities thathave seen a decline in market value due to changes in interest rates.

 

#### *Foreign CurrencyExchange*

#### * *

We face exposure, due to purchases of raw materials from Japanesesuppliers, to adverse movements in the value of the Japanese Yen.  This exposure may change over time, andcould have a materially adverse effect on our financial results.  We may attempt to limit this exposure bypurchasing forward contracts, as required. Most of our liabilities are settled within 90 days of receipt ofmaterials.  At December 31, 2003,our liabilities relating to Japanese Yen were approximately $191,000.

 

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

 

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

 

Based on an evaluation of our disclosure controls and procedures (asdefined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of1934), the chief executive officer and chief financial officer have concludedthat our disclosure controls and procedures as of the end of the three monthsended December 31, 2003, are effective to ensure that information requiredto be disclosed by us in the reports that we file or submit under the ExchangeAct is recorded, processed, summarized and reported within the time periodsspecified in the SEC’s rules and forms and are operating properly.

 

*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.

 

25

----

 

**PART II - OTHERINFORMATION**

 

**Item 5. Other Information**

 

In June 2003, we entered into a Contract Manufacturing Agreement,a Loan 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, whichbecame effective on September 19, 2003. Under the Medtronic Agreement, we have granted Medtronic Xomed exclusiverights to distribute our ENT EndoSheaths and ENT endoscopes to ENTpractitioners in the United States and Canada. The information included in Part I, Item 2 under the caption“Management’s Discussion and Analysis of Financial Condition and Results ofOperations” is hereby incorporated by reference.

 

**Item 6. Exhibits and Reports on Form 8-K**

 

(a)                                  Exhibits

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

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

 

(b)                                 Reports on Form 8-K

None.

 

##### **SIGNATURES**

 

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

 
| VISION-SCIENCES, INC.        |
|------------------------------|
|                         |   |
|                         |   |
| Date: February 13, 2004 | /s/ Ron Hadani |   |
|                         | Ron Hadani |
|                         | President, CEO (Duly Authorized Officer) |
|                         |   |
|                         |   |
| Date: February 13, 2004 | /s/ James A. Tracy |   |
|                         | James A. Tracy |
|                         | Vice President Finance, Chief Financial Officer and  Controller (Principal Financial Officer and Principal  Accounting Officer) |
|                              |  |  |  |

 

26

----