**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 ENDEDSeptember 30, 2003**

 

**COMMISSION FILENUMBER 0-20970**

 

**VISION-SCIENCES, INC.**

(Exact name of registrant as specified in itscharter)

 
| **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 by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Actof 1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirement for the past 90 days.

 

| Yes  ý |   | No  o |
|-----------------------|--------|-----------------|

 

Indicate by checkmark whether the registrant is an accelerated filer (as defined in Rule 12b-2of the Exchange Act).

 

| Yes  o |   | No  ý |
|------------------|--------|----------------------|

 

Indicate the number of shares outstanding of each of the issuer’sclasses of common stock, as of September 30, 2003.

 

|             | Common Stock, par value of $.01 |               |   | 30,207,828 |
|------------------|---------------------------------|--------------------|--------|------------|
| (Title of Class) |                            | (Number of Shares) |

 

 

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**VISION-SCIENCES,INC.**

**TABLEOF 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 4.   Submission of Matters to a Vote of Stockholders                                             |   |
|      |                                                                                                       |   |
|      | Item 5.   Other Information                                                                           |   |
|      |                                                                                                       |   |
|      | Item 6.   Exhibits and Reports on Form 8-K                                                            |   |
|      |                                                                                                       |   |
|      | Signatures                                                                                                 |   |
|      |                                                                                                       |   |
|      | Exhibits                                                                                                   |   |

 

2

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

**Item 1****: FINANCIALSTATEMENTS**

 

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

**CONSOLIDATED BALANCESHEETS**

**(Unaudited)**

 
|                                                                                                                                                      |   | **September 30,  2003** |      | **March 31,  2003** |   |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------------|-----------|--------------------------|--------|
| ASSETS                                                                                                                                                    |   |                         |      |                     |   |
| Current Assets:                                                                                                                                           |   |                         |      |                     |   |
| Cash and cash equivalents                                                                                                                                 |   | $                            | 375,663   |                     | $      | 2,744,143 |   |
| Marketable securities                                                                                                                                     |   | 2,139,355                    |      | 125,072                  |   |
| Accounts receivable, net of allowance for  doubtful accounts of $73,425 and $77,185, respectively                                                         |   | 1,167,572                    |      | 736,711                  |   |
| Inventories                                                                                                                                               |   | 1,107,413                    |      | 1,160,372                |   |
| Prepaid expenses and deposits                                                                                                                             |   | 45,500                       |      | 51,113                   |   |
| Total current assets                                                                                                                                      |   | 4,835,503                    |      | 4,817,411                |   |
|                                                                                                                                                      |   |                         |      |                     |   |
| Property and Equipment, at cost:                                                                                                                          |   |                         |      |                     |   |
| Machinery and equipment                                                                                                                                   |   | 3,436,398                    |      | 3,393,099                |   |
| Furniture and fixtures                                                                                                                                    |   | 212,002                      |      | 208,934                  |   |
| Leasehold improvements                                                                                                                                    |   | 471,886                      |      | 467,620                  |   |
|                                                                                                                                                      |   | 4,120,286                    |      | 4,069,653                |   |
| Less-Accumulated depreciation and amortization                                                                                                            |   | 3,634,633                    |      | 3,529,977                |   |
|                                                                                                                                                      |   | 485,653                      |      | 539,676                  |   |
|                                                                                                                                                      |   |                         |      |                     |   |
| Advance to Three BY Ltd                                                                                                                                   |   | 216,500                      |      | —                   |   |
|                                                                                                                                                      |   |                         |      |                     |   |
| Other assets, net of accumulated  amortization of $44,258 and $41,087, respectively                                                                       |   | 86,588                       |      | 89,759                   |   |
| Total assets                                                                                                                                              |   | $                            | 5,624,244 |                     | $      | 5,446,846 |   |
|                                                                                                                                                      |   |                         |      |                     |   |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                 |   |                         |      |                     |   |
| Current Liabilities:                                                                                                                                      |   |                         |      |                     |   |
| Acceptances payable to a bank                                                                                                                             |   | $                            | 28,902    |                     | $      | 10,621 |   |
| Accounts payable                                                                                                                                          |   | 472,712                      |      | 294,312                  |   |
| Accrued expenses                                                                                                                                          |   | 867,349                      |      | 804,139                  |   |
| Total current liabilities                                                                                                                                 |   | 1,368,963                    |      | 1,109,072                |   |
|                                                                                                                                                      |   |                         |      |                     |   |
| Potential obligations to non-qualified  option holders                                                                                                    |   | 829,100                      |      | 201,648                  |   |
|                                                                                                                                                      |   |                         |      |                     |   |
| Stockholders’ Equity:                                                                                                                                |   |                         |      |                     |   |
| Common stock, $.01 par value–                                                                                                                        |   |                         |      |                     |   |
| Authorized—50,000,000 shares Issued and  outstanding—30,207,828 shares at September 30, 2003 and 29,588,280  shares at March 31, 2003 |   | 302,078                      |      | 295,882                  |   |
| Additional paid-in capital                                                                                                                                |   | 60,523,343                   |      | 60,082,930               |   |
| Accumulated deficit                                                                                                                                       |   | (57,399,240                  | )         | (56,242,686              | )      |
| Total stockholders’ equity                                                                                                                           |   | 3,426,181                    |      | 4,136,126                |   |
| Total liabilities and stockholders’ equity                                                                                                           |   | $                            | 5,624,244 |                     | $      | 5,446,846 |   |

 

See accompanying notes to consolidatedfinancial statements.

 

3

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

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

**(Unaudited)**

 
|                                                                  |   | **Three  Months Ended  September 30,** |      | **Six Months  Ended  September 30,** |   |
|-----------------------------------------------------------------------|--------|---------------------------------------------|-----------|-------------------------------------------|--------|
|                                                                  |   | **2003**                                    |      | **2002**                                  |   | **2003** |   | **2002** |   |
| Net sales                                                             |   | $                                           | 2,106,754 |                                      | $      | 1,512,124 |   | $ | 4,067,237 |   | $ | 3,246,583 |   |
| Cost of sales                                                         |   | 1,304,769                                   |      | 1,091,678                                 |   | 2,507,666 |   | 2,364,164 |   |
|                                                                  |   |                                        |      |                                      |   |   |   |   |   |
| Gross profit                                                          |   | 801,985                                     |      | 420,446                                   |   | 1,559,571 |   | 882,419 |   |
|                                                                  |   |                                        |      |                                      |   |   |   |   |   |
| Selling, general and administrative  expenses (1)                     |   | 936,327                                     |      | 795,095                                   |   | 1,807,752 |   | 1,583,154 |   |
| Research and development expenses (1)                                 |   | 135,695                                     |      | 95,922                                    |   | 295,334 |   | 190,462 |   |
| Stock-based compensation                                              |   | 579,235                                     |      | (91,576                                   | )      | 634,988 |   | (186,083 | ) |
| Loss from operations                                                  |   | (849,272                                    | )         | (378,995                                  | )      | (1,178,503 | ) | (705,114 | ) |
|                                                                  |   |                                        |      |                                      |   |   |   |   |   |
| Interest income                                                       |   | 6,541                                       |      | 12,087                                    |   | 14,713 |   | 24,234 |   |
| Interest expense                                                      |   | —                                      |      | (146                                      | )      | — |   | (724 | ) |
| Other income, net                                                     |   | 3,625                                       |      | 3,133                                     |   | 7,236 |   | 10,555 |   |
|                                                                  |   |                                        |      |                                      |   |   |   |   |   |
| Net loss                                                              |   | $                                           | (839,106  | )                                         | $      | (363,921 | ) | $ | (1,156,554 | ) | $ | (671,049 | ) |
|                                                                  |   |                                        |      |                                      |   |   |   |   |   |
| Basic and diluted net loss per common share                           |   | $                                           | (0.03     | )                                         | $      | (0.01 | ) | $ | (0.04 | ) | $ | (0.02 | ) |
|                                                                  |   |                                        |      |                                      |   |   |   |   |   |
| Shares used in computing basic and diluted  net loss per common share |   | 30,138,269                                  |      | 27,198,712                                |   | 30,063,148 |   | 27,192,314 |   |

 

----

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

 
| Research and development expenses             |   | $      | 482,170 |   | $ | (84,111 | )      | $      | 519,563 |   | $ | (258,472 | ) |
|-----------------------------------------------|--------|--------|---------|--------|---|---------|--------|--------|---------|--------|---|----------|---|
| Selling, general and administrative  expenses |   | 97,065 |    | (7,465 | ) | 115,425 |   | 72,389 |    |
| Total                                         |   | $      | 579,235 |   | $ | (91,576 | )      | $      | 634,988 |   | $ | (186,083 | ) |

 

See accompanying notes to consolidatedfinancial statements.

 

4

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

**CONSOLIDATEDSTATEMENT OF STOCKHOLDERS’ EQUITY**

** (Unaudited)**

 
|                                                                  |   | **Common  Stock**     |   |                |    |                            |   | **Total  Stockholders’  Equity** |   | **Total  Comprehensive  Loss** |        |
|-----------------------------------------------------------------------|--------|-----------------------|--------|---------------------|---------|---------------------------------|--------|---------------------------------------|--------|--------------------------------|-------------|
|                                                                  |   | **Number  of Shares** |   | **$ 01  Par Value** |    | **Additional  Paid-in-Capital** |   | **Accumulated  Deficit**              |   |                           |        |
|                                                                  |   |                  |   |                |    |                            |   |                                  |   |                           |        |   |   |
| 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 |   |                  |   |                |    | 7,536                           |   | —                                |   | 7,536                          |        |   |   |
| Exercise of incentive stock options                                   |   | 95,450                |   | 955                 |    | 109,106                         |   |                                  |   | 110,061                        |        |   |   |
| Net loss                                                              |   | —                |   | —              |    | —                          |   | (1,156,554                            | )      | (1,156,554                     | )           | $ | (1,156,554 | ) |
| Total comprehensive loss                                              |   |                  |   |                |    |                            |   |                                  |   |                           |        | $ | (1,156,554 | ) |
| Balance September 30, 2003                                       |   | 30,207,828            |   | $                   | 302,078 |                            | $      | 60,523,343                            |   | $                              | (57,399,240 | ) | $ | 3,426,181 |   |   |   |

 

See accompanying notes to consolidatedfinancial statements.

 

5

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

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(Unaudited)**

 
|                                                                                              |   | **Six Months  Ended  September 30, 2003** |       | **Six Months  Ended  September 30, 2002** |   |
|---------------------------------------------------------------------------------------------------|--------|------------------------------------------------|------------|------------------------------------------------|--------|
| Cash flows from operating activities:                                                             |   |                                           |       |                                           |   |
| Net loss                                                                                          |   | $                                              | (1,156,554 | )                                              | $      | (671,049 | ) |
| Adjustments to reconcile net loss to net  cash used for operating activities:                     |   |                                           |       |                                           |   |
| Depreciation and amortization                                                                     |   | 107,827                                        |       | 108,083                                        |   |
| Stock compensation for non-qualified  options                                                     |   | 634,988                                        |       | (186,083                                       | )      |
| Changes in assets and liabilities:                                                                |   |                                           |       |                                           |   |
| Accounts receivable                                                                               |   | (430,861                                       | )          | 214,577                                        |   |
| Inventories                                                                                       |   | 52,959                                         |       | (156,861                                       | )      |
| Prepaid expenses and deposits                                                                     |   | 5,613                                          |       | (4,145                                         | )      |
| Accounts payable                                                                                  |   | 178,400                                        |       | 139,715                                        |   |
| Accrued expenses                                                                                  |   | 63,210                                         |       | (159,937                                       | )      |
|                                                                                              |   |                                           |       |                                           |   |
| Net cash used for operating activities                                                            |   | (544,418                                       | )          | (715,700                                       | )      |
|                                                                                              |   |                                           |       |                                           |   |
| Cash flows used for investing activities                                                          |   |                                           |       |                                           |   |
| Increase in marketable securities                                                                 |   | (2,014,283                                     | )          | (1,878,668                                     | )      |
| Purchase of property and equipment, net                                                           |   | (50,633                                        | )          | (88,055                                        | )      |
| Advances to Three BY Ltd                                                                          |   | (216,500                                       | )          | —                                         |   |
|                                                                                              |   |                                           |       |                                           |   |
| Net cash used for investing activities                                                            |   | (2,281,416                                     | )          | (1,966,723                                     | )      |
|                                                                                              |   |                                           |       |                                           |   |
| Cash flows provided by (used for) financing  activities:                                          |   |                                           |       |                                           |   |
| Payments on note payable for leasehold  improvements                                              |   | —                                         |       | (23,989                                        | )      |
| Proceeds from acceptances payable to a bank                                                       |   | 18,281                                         |       | 20,195                                         |   |
| Proceeds from the sale of common stock, net                                                       |   | 329,012                                        |       | —                                         |   |
| Exercise of stock options                                                                         |   | 110,061                                        |       | 20,500                                         |   |
| Net cash provided by financing activities                                                         |   | 457,354                                        |       | 16,706                                         |   |
|                                                                                              |   |                                           |       |                                           |   |
| Net decrease in cash and cash equivalents                                                         |   | (2,368,480                                     | )          | (2,665,717                                     | )      |
| Cash and cash equivalents, beginning of  period                                                   |   | 2,744,143                                      |       | 2,890,364                                      |   |
| Cash and cash equivalents, end of period                                                          |   | $                                              | 375,663    |                                           | $      | 224,647 |   |
|                                                                                              |   |                                           |       |                                           |   |
| 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 |   | $                                              | 627,452    |                                           | $      | (265,937 | ) |

 

See accompanying notes to consolidatedfinancial statements.

 

6

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

**NOTESTO CONSOLIDATED FINANCIAL STATEMENTS**

**(Unaudited)**

 

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

The consolidated financial statements included herein have beenprepared by the Company in accordance with accounting principles generallyaccepted in the United States of America, without audit, pursuant to the rulesand regulations of the Securities and Exchange Commission and include, in theopinion of management, 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**

 

The accompanying consolidated financial statements reflect theapplication of certain 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.                                       *Marketable Securities*:Marketable securities are carried at market value, which approximates amortizedcost.  The Company has classified itsinvestments in marketable securities as available-for-sale securities.  At September 30, 2003, the Company’smarketable securities consisted of commercial paper and a certificate ofdeposit with a weighted average maturity of 96 days.

 

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

 
|            |   | **September 30,  2003** |      | **March 31,  2003** |   |
|-----------------|--------|------------------------------|-----------|--------------------------|--------|
|            |   |                         |      | **(audited)**            |   |
|            |   |                         |      |                     |   |
| Raw materials   |   | $                            | 555,477   |                     | $      | 567,008 |   |
| Work-in-process |   | 155,472                      |      | 155,723                  |   |
| Finished goods  |   | 396,464                      |      | 437,641                  |   |
|            |   | $                            | 1,107,413 |                     | $      | 1,160,372 |   |

 

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

 

7

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

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

 

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

 

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

 

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

 

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

 

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

 

The Company has recorded a valuation allowance equal to its netdeferred tax asset due to the uncertainty of realizing the benefit of thisasset.

 

8

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j.                                          *Accountingfor Derivatives*: In September 2000, the Emerging Issues TaskForce (“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.

 

Inaccordance with EITF 00-19, the Company has determined that outstanding optionsto non-employees as of September 30, 2003 to purchase 1,463,032 shares ofthe Company’s common stock should be designated as a liability.

 

TheCompany valued the non-qualified options outstanding to non-employees atSeptember 30, 2003 and 2002 using the Black-Scholes method.  The value of those options increased by$573,583 and decreased by $91,576 in the three months ended September 30,2003 and 2002, respectively.  TheCompany recorded the charge or credit to stock-based compensation in theaccompanying statements of operations for these periods.

 

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

 

In June 2003, the Company granted options topurchase 1,295,000 shares of common stock to its employees at an exercise priceof $1.04 per share.  The fair marketvalue of the common 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 six months ended September 30, 2003, the Companyrecognized $5,652 and $7,536, respectively of expense as stock-basedcompensation in the consolidated statement of operations.

 

9

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In accordance with the Financial Accounting StandardsBoard (FASB) Statement No. 148, *Accounting for Stock-Based Compensation – Transitionand Disclosure*, beginning in the quarter ending March 31, 2003,the Company adopted the disclosure requirements of FASB No. 148.  Had compensation expense for all stockoption grants to employees been determined under the fair value method at thegrant dates, consistent with the method prescribed by SFAS No. 123, theCompany’s net loss would have changed to the pro forma amounts indicated asfollows:

 
|                                                  |   | **Three Months Ended  September 30** |     | **Six Months Ended  September 30** |   |
|-------------------------------------------------------|--------|-------------------------------------------|----------|-----------------------------------------|--------|
|                                                  |   | **2003**                                  |     | **2002**                                |   | **2003** |   | **2002** |   |
| Net loss – as reported                           |   | $                                         | (839,106 | )                                       | $      | (363,921 | ) | $ | (1,156,554 | ) | $ | (671,049 | ) |
| Stock-based employee  compensation – as reported |   | 5,652                                     |     | —                                  |   | 7,536 |   | — |   |
| Pro forma stock-based  employee compensation          |   | (69,000                                   | )        | (86,300                                 | )      | (138,000 | ) | (172,600 | ) |
| Net loss - pro forma                                  |   | $                                         | (902,454 | )                                       | $      | (450,221 | ) | $ | (1,287,018 | ) | $ | (843,649 | ) |
|                                                  |   |                                      |     |                                    |   |   |   |   |   |
| Net loss per share – as  reported                |   | $                                         | (.03     | )                                       | $      | (.01 | ) | $ | (.04 | ) | $ | (.02 | ) |
| Stock-based employee  compensation – as reported |   | —                                    |     | —                                  |   | — |   | — |   |
| Pro forma stock-based  employee compensation          |   | —                                    |     | (.01                                    | )      | — |   | (.01 | ) |
| Net loss per share -  pro forma                       |   | $                                         | (.03     | )                                       | $      | (.02 | ) | $ | (.04 | ) | $ | (.03 | ) |

 

*l.**                                         RecentlyIssued Accounting Standards*

 

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

 

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InNovember 2002, the EITF reached consensus on EITF No. 00-21, *RevenueArrangements with Multiple Deliverables*.  Revenue arrangements with multiple deliverables includearrangements that provide for the delivery or performance of multiple products,services and/or rights to use assets where performance may occur at differentpoints in time or over different periods of time.  The Company may enter into arrangements for multiple deliverablesthat occur at different points in time if it enters into a contract to sellendoscopes and EndoSheaths on a per-procedure basis.  EITF No. 00-21 is effective for the Company beginningOctober 1, 2003.  The Company hasnot completed the evaluation of the impact, if any, of this EITF on itsoperations.

 

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

 

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

 

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

 

In June 2003,the Company entered into a Contract Manufacturing Agreement, a Loan Agreementand a Pledge Agreement (collectively, the “3BY Agreements”) with Three BY Ltd.,an Israeli company (“3BY”).  The 3BYAgreements provide for, among other things, the manufacture of certain of theCompany’s products by 3BY, and a loan of up to $267,500 by the Company to 3BYfor the purchase and installation of certain manufacturing equipment by 3BY, at3BY’s facility, to be used to manufacture certain of the Company’sproducts.  As of September 30,2003, the Company had advanced $216,500 to 3BY, and expects to advance thecomplete loan by October 31, 2003. After the manufacturing equipment is completed, and production hasbegun, the Company and 3BY plan to establish a repayment schedule, according tothe 3BY Agreements.

 

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**5.****                                      SegmentInformation**

 

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

 

All segments follow the accounting policies described in the summary ofsignificant accounting policies.  TheCompany evaluates 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 September 30,2003 was $0.  Data regardingmanagement’s view of the Company’s segments are provided in the followingtables.

 

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| **Three months ended September 30,** |   | **Medical** |      | **Industrial** |   | **Corporate** |   | **Adjustments** |   | **Total**  |   |
|-------------------------------------------|--------|-------------|-----------|----------------|--------|---------------|--------|-----------------|--------|------------|--------|
| **2003**                                  |   |        |      |           |   |          |   |            |   |       |   |
| Sales to external customers               |   | $           | 1,399,598 |           | $      | 707,156       |   | $               | — |       | $      | — |   | $ | 2,106,754 |   |
| Intersegment sales                        |   | —      |      | 409,833        |   | —        |   | (409,833        | )      | —     |   |
| Operating income (loss)                   |   | 16,853      |      | 3,758          |   | (869,883      | )      | —          |   | (849,272   | )      |
| Interest income (expense)                 |   | —      |      | —         |   | 6,541         |   | —          |   | 6,541      |   |
| Depreciation and amortization             |   | 42,277      |      | 10,062         |   | —        |   | —          |   | 52,339     |   |
| Advance to 3BY Ltd.                       |   | 146,522     |      | —         |   | —        |   | —          |   | 146,522    |   |
| Other significant non-cash items:         |   |        |      |           |   |          |   |            |   |       |   |
| Stock-based compensation                  |   | 321         |      | 107            |   | 578,807       |   | —          |   | 579,235    |   |
| Expenditures for fixed assets             |   | 30,520      |      | 262            |   | —        |   | —          |   | 30,782     |   |
|                                      |   |        |      |           |   |          |   |            |   |       |   |
| **2002**                                  |   |        |      |           |   |          |   |            |   |       |   |
| Sales to external customers               |   | $           | 848,025   |           | $      | 664,099       |   | $               | — |       | $      | — |   | $ | 1,512,124 |   |
| Intersegment sales                        |   | —      |      | 151,041        |   | —        |   | (151,041        | )      | —     |   |
| Operating income (loss)                   |   | (268,372    | )         | (14,863        | )      | (95,760       | )      | —          |   | (378,995   | )      |
| Interest income (expense)                 |   | —      |      | (146           | )      | 12,087        |   | —          |   | 11,941     |   |
| Depreciation and amortization             |   | 45,804      |      | 9,870          |   | —        |   | —          |   | 55,674     |   |
| Advance to 3BY Ltd.                       |   | —      |      | —         |   | —        |   | —          |   | —     |   |
| Other significant non-cash items:         |   |        |      |           |   |          |   |            |   |       |   |
| Stock-based compensation                  |   | —      |      | —         |   | (91,576       | )      | —          |   | (91,576    | )      |
| Expenditures for fixed assets             |   | 42,999      |      | 19,302         |   | —        |   | —          |   | 62,301     |   |
|                                      |   |        |      |           |   |          |   |            |   |       |   |
| **Six months ended  September 30,**  |   |        |      |           |   |          |   |            |   |       |   |
| **2003**                                  |   |        |      |           |   |          |   |            |   |       |   |
| Sales to external customers               |   | $           | 2,670,615 |           | $      | 1,396,622     |   | $               | — |       | $      | — |   | $ | 4,067,237 |   |
| Intersegment sales                        |   | —      |      | 556,217        |   | —        |   | (556,217        | )      | —     |   |
| Operating income (loss)                   |   | 40,675      |      | (20,771        | )      | (1,198,407    | )      | —          |   | (1,178,503 | )      |
| Interest income (expense)                 |   | —      |      | —         |   | 14,713        |   | —          |   | 14,713     |   |
| Depreciation and amortization             |   | 87,808      |      | 20,019         |   | —        |   | —          |   | 107,827    |   |
| Advance to 3BY Ltd.                       |   | 216,500     |      | —         |   | —        |   | —          |   | 216,500    |   |
| Other significant non-cash items:         |   |        |      |           |   |          |   |            |   |       |   |
| Stock-based compensation                  |   | 429         |      | 143            |   | 634,416       |   | —          |   | 634,988    |   |
| Expenditures for fixed assets             |   | 49,121      |      | 1,512          |   | —        |   | —          |   | 50,633     |   |
| Total assets                              |   | 2,259,918   |      | 979,314        |   | 2,606,992     |   | (221,980        | )      | 5,624,244  |   |
|                                      |   |        |      |           |   |          |   |            |   |       |   |
| **2002**                                  |   |        |      |           |   |          |   |            |   |       |   |
| Sales to external customers               |   | $           | 1,856,031 |           | $      | 1,390,552     |   | $               | — |       | $      | — |   | $ | 3,246,583 |   |
| Intersegment sales                        |   | —      |      | 353,914        |   | —        |   | (353,914        | )      | —     |   |
| Operating income (loss)                   |   | (511,362    | )         | (10,029        | )      | (183,723      | )      | —          |   | (705,114   | )      |
| Interest income (expense)                 |   | —      |      | (724           | )      | 24,234        |   | —          |   | 23,510     |   |
| Depreciation and amortization             |   | 90,021      |      | 18,062         |   | —        |   | —          |   | 108,083    |   |
| Advance to 3BY Ltd.                       |   | —      |      | —         |   | —        |   | —          |   | —     |   |
| Other significant non-cash items:         |   |        |      |           |   |          |   |            |   |       |   |
| Stock-based compensation                  |   | —      |      | —         |   | (186,083      | )      | —          |   | (186,083   | )      |
| Expenditures for fixed assets             |   | 57,860      |      | 30,195         |   | —        |   | —          |   | 88,055     |   |
| Total assets                              |   | 1,807,078   |      | 1,142,370      |   | 2,446,734     |   | (256,656        | )      | 5,139,526  |   |

 

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

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

 

CriticalAccounting Policies and Estimates

 

This discussion and analysis of our financialcondition and results of operations is based upon our Consolidated FinancialStatements, which have been prepared in accordance with accounting principlesgenerally accepted in the United States. See the Notes to the Consolidated Financial Statements includedelsewhere herein.  Certain of ouraccounting policies require the application of judgment in selecting theappropriate assumptions for calculating financial estimates.  By their nature these judgments are subjectto an inherent degree of uncertainty. We periodically evaluate the judgments and estimates used for ourcritical accounting policies to ensure that such judgments and estimates arereasonable for our interim and year-end reporting requirements.  These judgments and estimates are based uponour historical experience, current trends and information available from othersources, as appropriate.  If differentconditions result from those assumptions used in our judgment, the resultscould be materially different from our estimates.  Our critical accounting policies include the following:

 

### *Revenue Recognition*

### * *

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.

 

# ***PotentialObligations 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-qualifiedoptions are derived from pricing models that consider current market andcontractual prices for the underlying financial instruments or commodities, aswell as time value and yield curve or volatility factors underlying thepositions.  Pricing models and theirunderlying assumptions impact the amount and timing of unrealized gains andlosses recognized, and the use of different pricing models or assumptions couldproduce different financial results. The Company uses the Black-Scholes method for determining the value ofthe potential obligation to non-qualified option holders.

 

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We account for certain non-qualified options granted to employees topurchase our common stock in accordance with SFAS No. 123, *Accounting for**Stock-BasedCompensation.*  If the fairmarket value of the underlying stock at the date of grant is greater than theoption price, we recognize compensation expense for the difference between themarket price and the option price over the life of the options.

 

Results of Operations

 

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

 

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

 

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, sigmoidoscopes and bronchoscopes.  The EndoSheaths allow the health-careproviders to process patients economically by permitting the providers to avoidreprocessing the endoscopes after each use. In addition, the EndoSheaths are sterile, thus helping to ensure eachpatient a contaminant-free procedure.

 

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.

 

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.

 

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Sales

*Q2 04 Compared to Q203*

 

Net sales for the threemonths ended September 30, 2003 (“Q2 04”) were $2,106,754, an increase of$594,630, or 39%, compared to the three-month period ended September 30,2002 (“Q2 03”).  During Q2 04, sales ofthe medical segment were $1,399,598, an increase of $551,573, or 65%, and salesof the industrial segment were $707,156, an increase of $43,057, or 6%,compared to Q2 03.  Medical segmentsales to the ENT market include sales of our own ENT endoscope, and ENTEndoSheaths for our ENT endoscope and for the ENT endoscopes of most othermajor manufacturers.  Sales to the GIand pulmonary markets include sales of our proprietary endoscopes andEndoSheaths for use with those endoscopes. Sales termed Other include repairs of our endoscopes andaccessories.  In the medical segment,the sales and changes in sales by market were as follows ($000’s):

 
| **Market** |   | **Q2 04** |   | **Q2 03** |   | **Increase  (Decrease)** |   | **Percent** |   |
|------------|--------|-----------|--------|-----------|--------|--------------------------|--------|-------------|--------|
| ENT        |   | $         | 1,174  |      | $      | 709                      |   | $           | 465    |   | 66 | % |
| GI         |   | 146       |   | 101       |   | 45                       |   | 45          | %      |
| Pulmonary  |   | 19        |   | 2         |   | 17                       |   | 850         | %      |
| Other      |   | 61        |   | 36        |   | 25                       |   | 69          | %      |
| Total      |   | $         | 1,400  |      | $      | 848                      |   | $           | 552    |   | 65 | % |

#### * *

#### *Medical Segment – ENT Market*

#### * *

Sales of EndoSheaths in Q2 04 were approximately $839,000, an increaseof approximately $274,000, or 48%, compared to Q2 03.  In addition, sales of ENT endoscopes were approximately $335,000,an increase of approximately $191,000, or 133%, compared to Q2 03.  Included in the sales of ENT EndoSheaths inQ2 04 are sales of approximately $10,000 of our new ENT Channeled EndoSheathand ENT Sensory EndoSheath, compared to $0 in Q2 03.  The ENT Channeled EndoSheath is designed to allow health-careproviders to perform therapeutic procedures in their offices, usingconventional diagnostic ENT endoscopes, that currently they can only performusing a therapeutic ENT endoscope that contains a channel, typically in ahospital setting.  The channel containedin the ENT Channeled EndoSheath allows the health-care provider to pass tools,such as biopsy forceps or brushes, through it, or to irrigate the sinus cavityof a patient, a common procedure after sinus surgery. Therapeutic ENTendoscopes are typically only found in hospital settings as they represent alarge investment.

 

The ENT Sensory EndoSheath, also designed to be used with conventionalflexible ENT endoscopes, allows health-care providers to test for reflux andswallowing disorders in their offices. After sliding the ENT Sensory EndoSheath on to a conventional ENTendoscope, small puffs of air are passed through a channel in the EndoSheathallowing the health-care provider to assess sensation in the larynx byilliciting an airway protective reflex. We believe the ENT Sensory EndoSheath, used in conjunction with an airpulse sensory stimulator, allows health-care providers to expand the use oftheir conventional flexible ENT endoscopes by performing tests in their officesthat currently they can perform only using more expensive therapeutic ENTendoscopes, typically found in hospital settings.  We received clearance from the FDA in July 2003 to marketthe ENT Sensory EndoSheath.

 

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The increase in sales of ENT EndoSheaths was due primarily to higherunit volume from the domestic and international markets.  Sales to domestic customers wereapproximately $492,000, an increase of approximately $131,000, or 36%, comparedto Q2 03, with unit sales increasing to approximately 53,100 from 33,800 in Q203.  Sales to international distributorswere approximately $347,000, an increase of approximately $143,000, or 70%,with unit sales increasing to approximately 58,600 from 34,900 in Q2 03.  The increase in sales to domestic customersresulted primarily from the initial shipment of approximately 22,900 units toMedtronic Xomed, Inc. (“Medtronic Xomed”) under an exclusive marketing anddistribution agreement (the “Medtronic Agreement”) signed with Medtronic Xomedon August 6, 2003, which became effective on September 19, 2003.  The terms and expected effect of theMedtronic Agreement are discussed below.

 

The increase in sales of ENT endoscopes was due primarily to higherunit volume from the domestic and international markets.  Sales to domestic customers wereapproximately $220,000, and increase of $110,000, or 100%, compared to Q203.  Sales to international distributorswere approximately $115,000, an increase of $81,000, or 245%, compared to Q203.  In general, the sales cycle ofendoscopes is longer and less predictable than the sales cycle ofEndoSheaths.  Sales of endoscopes todomestic customers included $24,300 to Medtronic Xomed.

 

The initial term of the Medtronic Agreement is three years.  Thereafter, the Medtronic Agreement will beautomatically renewed for successive one-year periods, unless terminated byeither party upon advance written notice. Under the Medtronic Agreement, we have granted Medtronic Xomed exclusivedistribution rights in the United States and Canada to market and sell our ENTEndoSheaths and ENT endoscopes to ENT practitioners.  Medtronic Xomed has agreed to certain minimum purchaserequirements for the initial twelve-month period of the term.  We expect the Medtronic Agreement willresult in an increase in sales of our ENT EndoSheaths and ENT endoscopes due tothe significantly greater marketing and sales capabilities of MedtronicXomed.  In addition, the MedtronicAgreement is expected to facilitate the introduction of new ENT products byallowing quicker market acceptance of these products.  As a result of the Medtronic Agreement, the success of our ENTproduct lines will be substantially dependent upon the success of the marketingand sales activities of Medtronic Xomed over which we have limited control.

 

The increase in sales to international distributors is primarily due tohigher demand, especially from Europe and Australia.  In addition to continuing to promote our existing products to theinternational market, we plan to introduce our new products to thesedistributors.  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.  Despite the increase in sales tointernational distributors and our continuing marketing and sales efforts ininternational markets, there can be no assurance that our sales tointernational distributors will continue to increase at the same rate, or atall.

 

#### *Medical Segment – GI and Pulmonary Markets*

#### * *

The increase in sales to the GI (Gastrointestinal) market in Q2 04 was dueprimarily to higher prices for GI EndoSheaths. Unit sales of GI EndoSheaths were flat compared to Q2 03.  We expect demand for these EndoSheaths willremain flat, or decline, due to reimbursement rates to health-care providersbeing insufficient to support the use of our GI EndoSheaths for thosegastrointestinal procedures.

 

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The increase in sales to the pulmonary market was due primarily tohigher demand for our bronchoscopes.  InQ2 04 we sold two bronchoscopes, whereas we sold none in Q2 03.  The sales cycle for all endoscopes can belengthy, especially for our proprietary endoscopes, due primarily to thecommitment that customers must make to use our proprietary EndoSheath.  We expect sales to this market will improve,compared to the fiscal year ended March 31, 2003, but there is noassurance that such an improvement will occur.

 

*Industrial Segment*

 

The increase in sales of the industrial segment was due to higherdemand for jet engine repair services, offset by lower demand for new equipmentdue to continued slowness in the market for new jet engines.

 

*6 Months 04 Compared to 6 Months 03*

 

Net sales for the six monthsended September 30, 2003 (“6M 04”) were $4,067,237, an increase of$820,654, or 25%, compared to the six-month period ended September 30,2002 (“6M 03”).  During 6M 04, sales ofthe medical segment were $2,670,615, an increase of $814,584, or 44%, comparedto 6M 03.  Sales of the industrialsegment were $1,396,622, an increase of $6,070, or 0%, compared to 6M 03.  In the medical segment, the sales andchanges in sales by market were as follows ($000’s):

 
| **Market** |   | **6M 04** |   | **6M 03** |   | **Increase  (Decrease)** |   | **Percent** |   |
|------------|--------|-----------|--------|-----------|--------|--------------------------|--------|-------------|--------|
| ENT        |   | $         | 2,232  |      | $      | 1,538                    |   | $           | 694    |   | 45 | % |
| GI         |   | 297       |   | 220       |   | 77                       |   | 35          | %      |
| Pulmonary  |   | 32        |   | 29        |   | 3                        |   | 59          | %      |
| Other      |   | 109       |   | 69        |   | 40                       |   | 36          | %      |
| Total      |   | $         | 2,670  |      | $      | 1,856                    |   | $           | 814    |   | 44 | % |

 

*Medical Segment – ENT Market*

 

Sales of EndoSheaths in6M 04 were approximately $1,724,000, an increase of $491,000, or 40%, comparedto 6M 03.  In addition, sales of ENT endoscopeswere approximately $508,000, an increase of approximately $203,000, or 67%,compared to 6M 03.  The sales ofEndoSheaths include sales of approximately $14,000 of our new ENT ChanneledEndoSheath and the ENT Sensory EndoSheath.

 

Sales of EndoSheaths in6M 04 to domestic customers were approximately $893,000, an increase of$169,000, or 23%, while sales of EndoSheaths to international distributors wereapproximately $831,000, an increase of $322,000, or 63%, compared to 6M 03.  The unit volume of ENT EndoSheaths increasedby 50% to approximately 231,500 in 6M 04 from 154,800 in 6M 03.  The unit volume to domestic customersincreased by 34%, while it increased by 62% to international distributors.  The lower percentage increase in domesticdollar sales of EndoSheaths compared to the increase in units is due primarilyto the initial shipments of EndoSheaths to Medtronic Xomed.  Although the average unit sales price ofEndoSheaths sold under the Medtronic Agreement is lower than the average unitsales price of EndoSheaths sold directly to domestic customers, we expect thatthe increased unit sales will result in a total contribution margin comparableto the contribution margin in our FY 04 budget.  The average sales price of EndoSheaths sold to internationaldistributors remained approximately the same for 6M 04, compared to 6M 03.

 

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Sales of endoscopes in 6M04 to domestic customers, including Medtronic Xomed, were approximately$287,000, an increase of $50,000 due primarily to a higher volume of units ataverage selling prices that were lower by approximately 6%, compared to 6M03.  Sales of endoscopes tointernational distributors were approximately $221,000, an increase of $154,000due primarily to higher unit volume, and higher average selling price increaseof approximately 4%.

 

*Medical Segment – GI and PulmonaryMarkets*

 

Sales to the GI marketincreased due to higher unit prices, offset by lower unit volume of 8%, dueagain to the lack of reimbursement. Sales to the pulmonary market were marginally higher due to higher unitvolume of EndoSheaths.

 

*Industrial Market*

 

Sales to the industrial market were marginally higher in 6M 04,compared to 6M 03.  We expect sales tothis market will remain approximately the same in FY 04 as in FY 03.

 

Gross Profit

 

Gross profit in Q2 04 increased to $801,985, or 38% of net sales,compared to $420,446, or 28% of net sales in Q2 03.  Gross profit in the medical segment was approximately $611,000 anincrease of $374,800, compared to Q2 03. Gross profit in the industrial segment was approximately $191,000, anincrease of $6,800, compared to Q2 03. The increase in gross profit in the medical segment was due primarily tothe higher volume of ENT EndoSheath and endoscope units sold to both thedomestic and international markets, and to lower unit costs of the ENTEndoSheath, resulting from full implementation of our new manufacturingequipment in Natick MA.  In addition,higher prices attained for GI EndoSheaths added to the increase in grossprofit.  In the industrial segment, theincrease in gross profit was due primarily to a more favorable product mix andhigher absorption of manufacturing overhead.

 

Gross profit in 6M 04 increased to $1,559,571, or 38% of sales, comparedto $882,419, or 27% of sales in 6M 03. Gross profit in the medical segment was approximately $1,206,400, anincrease of $723,300, compared to 6M 03. Gross profit in the industrial segment was approximately $353,100, adecrease of $46,200, compared to 6M 03. The primary causes of the change in gross profit for both segments in 6M04, compared to 6M 03 were the same as for Q2 04, compared to Q2 03.

 

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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 this transferof manufacturing is to lower our production costs.  As of September 30, 2003, we have advanced approximately$217,000 of the loan amount to 3BY. According to the 3BY Agreements, we will establish a repaymentschedule once the production line is operational.  Until that time, 3BY has provided us with asecurity interest in equipment of equal value. We expect shipments of GI and pulmonary EndoSheaths from 3BY will beginin January 2004.  We expectshipments of ENT EndoSheaths from 3BY will begin in February 2004.  As a result of the 3BY Agreements, we expectthat the per unit production costs of our EndoSheaths will decrease byapproximately 50%, thereby increasing our gross profit.

 

The Medtronic Agreement is expected to result in an increase in unitsales of our ENT EndoSheaths and ENT endoscopes, the gross profit benefits of whichwe expect will be offset by the lower unit sales prices to Medtronic Xomed,compared to our sales prices to domestic end users.  Additional benefits of the Medtronic Agreement include theelimination of the commission expense we currently pay to our independent salesrepresentatives for sales of ENT products, the potential reduction of othermarketing and sales expenses and the ability to obtain more rapid marketacceptance 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 Q2 04increased by $141,232, or 18%, compared to Q2 03.  SG&A expenses amounted to 44% and 53% of net sales in Q2 04and Q2 03, respectively.  SG&Aexpenses increased in the medical segment by approximately $38,000, dueprimarily to higher costs for legal fees related to intellectual property.  SG&A expenses declined in the industrialsegment by approximately $12,000, due primarily to lower costs forpersonnel.  SG&A expenses increasedby approximately $115,000 in the corporate segment due primarily to higher costsfor personnel and professional fees.

 

SG&A expensesincreased by $224,598, or 14%, in 6M 04, compared to 6M 03.  SG&A expenses increased in the medicalsegment by approximately $70,400, decreased by approximately $35,400 in theindustrial segment and increased by approximately $190,000 due primarily to thesame reasons as stated above.

 

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*Research and Development Expenses*

 

R&D expenses were$135,695, an increase of $39,773 in Q2 04, compared to Q2 03, and were 6% ofsales in Q2 04 and in Q2 03.  Theprimary causes for this increase were higher costs for additional personnelhired to work on developing new products for the medical segment, offset bylower costs for outside services in the corporate segment related to CMOSpatent applications.  We expect costsfor R&D will continue to be higher in FY 04, compared to FY 03, as weincrease our efforts to develop new products utilizing the technology inherentin our EndoSheaths.

 

R&D expenses were$295,334 in 6M 04, an increase of $104,872, compared to 6M 03, and were 7% ofsales in 6M 04, compared to 6% of sales in 6M 03.  The primary causes for the increase were higher costs foradditional personnel hired to work on developing new products for the medicalsegment.  R&D costs in the corporatesegment increased by approximately $4,000 in 6M 04, compared to 6M 03.

 

On May 29, 2003 wesigned a Development, Supply and Distribution Agreement (“DSDA”) withEndoscopic Technologies, Inc. (“ESTECH”), a company with certain proprietarytechnologies relating to methods for minimally-invasive cardiovascularsurgery.  In the DSDA, we and ESTECHhave agreed to use commercially reasonable and diligent efforts to complete thedevelopment of certain products being designed for minimally-invasive surgery,specifically for the treatment of coronary atrial fibrillation.   The total value of the product developmentcomponent of the DSDA is approximately $90,000.  According to the terms of the DSDA, as of June 30, 2003, wehad invoiced $45,000 to ESTECH, and recorded that total amount in a deferredrevenue account within accrued liabilities on the accompanying consolidatedfinancial statements.  In the threemonths ended September 30, 2003, we did not invoice ESTECH, nor did werecognize any revenue from this contract. We plan to utilize percentage-completion accounting to recognize revenuefrom this contract.  We expect tocomplete the product development stage of the DSDA in the fiscal quarter endingJune 30, 2004.

 

*Stock-based Compensation Expenses*

 

Stock-based compensationcosts increased by $670,811, due primarily to an increase in the fair value ofnon-qualified options.  This non-cashcost is computed by determining the change in the fair value of stock optionsgranted to non-employees of the Company. We use the Black-Scholes method to calculate the fair value.  This method uses stock price volatility, theclosing price of our common stock as traded on the Nasdaq SmallCap Market andother factors to determine the fair value of non-qualified options.  The increase in the closing price of ourcommon stock to $1.86 per share on the last trading day in the 52-week periodmeasured in Q2 04, from $1.14 per share for the comparable period in Q1 04, wasthe largest component in the change for the three months endedSeptember 30, 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 $821,071 in 6M 04, comparedto 6M 03, due primarily to the increase in the closing price of our commonstock, as discussed above.

 

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The net loss per share for Q2 04 was $.03, compared to a net loss of$.01 per share for Q2 03.  The net lossexcluding the non-cash charge for stock-based compensation costs was $259,871,or $.01 per share in Q2 04, compared to $455,497, or $.02 per share in Q2 03.

 

The net loss per share for 6M 04 was $.04, compared to $.02 in 6M 03.The net loss excluding the non-cash charge for stock-based compensation costswas $521,566, or $.02 per share in 6M 04, compared to $857,132, or $.03 pershare in 6M 03.

 

Operating Income (Loss)

 

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

 
| **Segment** |   | **Q2 04** |   | **Q2 03** |   | **Change** |   | **6M 04** |   | **6M 03** |   | **Change** |   |
|-------------|--------|-----------|--------|-----------|--------|------------|--------|-----------|--------|-----------|--------|------------|--------|
| Medical     |   | $         | 17     |      | $      | (268       | )      | $         | 285    |      | $      | 41         |   | $ | (511 | ) | $ | 552 |   |
| Industrial  |   | 4         |   | (15       | )      | 19         |   | (21       | )      | (10       | )      | (11        | )      |
| Corporate   |   | (870      | )      | (96       | )      | (774       | )      | (1,198    | )      | (184      | )      | (1,014     | )      |
| Total       |   | $         | (849   | )         | $      | (379       | )      | $         | (470   | )         | $      | (1,178     | )      | $ | (705 | ) | $ | (473 | ) |

 

For both the quarterly and six-month periods above, in the medicalsegment, the improved gross profit was the primary driver for the improvementin operating income (loss).  Thisimproved gross profit was partially offset by higher costs for SG&A andR&D expenses.  In the industrialsegment, the higher gross profit and lower SG&A expenses were the primarydrivers for the change.  In thecorporate segment, the higher costs for stock-based compensation fornon-qualified options to non-employees was the primary driver for the higherloss.  In addition, the corporatesegment incurred higher expenses for personnel costs and professional fees.

 

Liquidity and Capital Resources

 

At September 30,2003, our principal source of liquidity was working capital of approximately$3.5 million, including $2.5 million in cash, cash equivalents andmarketable securities.  AtSeptember 30, 2003, we had acceptances payable to a bank totalingapproximately $29,000.  We have pledged$125,000 to secure the acceptances payable.

 

We also have an agreementwith a bank, which includes a revolving line of credit under which we mayborrow up to $1,000,000, net of up to $250,000 of any outstanding letters ofcredit and banker’s acceptances. Borrowings under this loan arrangement must be fully cashcollateralized.  The agreement alsostipulates that when we achieve positive cash flow, as defined in theagreement, we will be eligible to negotiate changes to this loan arrangementthat may include changing the borrowing base for revolving loans, and therelease of the pledged cash collateral.

 

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Our cash and cash equivalentsdecreased by approximately $2,368,000 in the six months endedSeptember 30, 2003, due primarily to cash used for operations ofapproximately $544,000 and cash used for investing activities of approximately$2,281,000.  These uses were offset byselling new shares to non-affiliated investors for approximately $329,000, net,in a private placement in April 2003, cash generated by employee exercisesof stock options of approximately $110,000 and an increase in acceptancespayable to a bank of approximately $18,000. Our burn rate for cash, cash equivalents and marketable securities,excluding advances to 3BY, cash received from new equity and option exercises,was approximately $289,000 per quarter for 6M 04, reduced from approximately$404,000 per quarter for 6M 03.  Weexpect our current balance of cash, cash equivalents and marketable securitiesis sufficient to fund our operations at least for the next 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 September 30,2003 we have advanced approximately $217,000 of the loan amount to 3BY.  We expect to advance the remainder inOctober 2003.  According to the 3BYAgreements, we will establish a repayment schedule once the productionline is operational.  Until that time,3BY has provided us a security interest in equipment of equal value.

 

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

 

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

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

 

We have incurred losses since our inception, and losses are expected tocontinue at least during the fiscal year ending March 31, 2004 (“FY04”).  We have funded the lossesprincipally with the proceeds from public and private equity financings.  Although we do not anticipate the need foradditional financing in FY 04, management has decided that new financing may bedesirable.  However, there can be noassurance that additional funding will be available, or available on reasonableterms.

 

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## **Item 3**.  QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK

## ** **

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

 

#### *Interestand Market 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.

 

#### *ForeignCurrency Exchange*

#### * *

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 of materials.  At September 30, 2003, our liabilitiesrelating to Japanese Yen were approximately $73,000.

 

## **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-14(c) and 15d-14(c) 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 September 30, 2003, are designed 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 in an effectivemanner.

 

*b)**            Changes in InternalControls.*

 

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

 

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**PART II****- OTHERINFORMATION**

**Item4.  Submissionof Matters to a Vote of Stockholders**

 

We held the 2003 Annual General Meeting of Shareholders (the “AnnualMeeting”) on July 24, 2003.  At theAnnual Meeting, the following actions were taken:

 

1.               The stockholders re-elected Kenneth W.Anstey and Dr. Gerald B. Lichtenberger as Class III directors to serve for athree-year term.  Holders of 23,332,758shares of Common Stock voted for and holders of 27,740 shares of Common Stockwithheld voting for each of Mr. Anstey and Dr. Lichtenberger.  In addition to Mr. Anstey andDr. Lichtenberger, Mr. Katsumi Oneda, Mr. Lewis C. Pell,Mr. Ron Hadani, Mr. William F. Doyle andMr. John J. Wallace continue to serve on the Board of Directors.

2.               The stockholders approved our 2003Director Stock Option Plan.  Holders of23,264,777 shares of Common Stock voted for, holders of 92,671 shares of CommonStock voted against and holders of 3,050 shares of Common Stock abstained fromvoting on the acceptance of the 2003 Director Stock Option Plan.

3.               The stockholders ratified the selectionof BDO Seidman LLP as our independent public accountants for the fiscal yearending March 31, 2004.  Holders of23,347,098 shares of Common Stock voted for, holders of 11,100 shares of CommonStock voted against and holders of 2,300 shares of Common Stock abstained fromvoting on the ratification of BDO Seidman LLP as our independent publicaccountants.

 

**Item5.  OtherInformation**

 

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.

 

**Item6.  Exhibitsand Reports on Form 8-K**

 

(a)                                  Exhibits

10.1                                       ExclusiveDistribution Agreement, dated August 6, 2003, by and between theRegistrant and Medtronic Xomed, Inc.

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

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

 

(b)                                 Reports on Form 8-K

None.

 

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##### **SIGNATURES**

##### ** **

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the Registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 

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

 

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