** **

**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON, D. C. 20459**

 

**FORM 10-Q**

 

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

 

**FOR THEQUARTER ENDED September 30, 2004**

 

**COMMISSIONFILE NUMBER 0-20970**

 

**VISION-SCIENCES, INC.**

(Exactname of registrant as specified in its charter)

 

 

| **Delaware**                              |   | **13-3430173**          |
|-------------------------------------------|--------|-------------------------|
| (State  or other jurisdiction of          |   | (IRS  Employer          |
| incorporation  or organization)           |   | Identification  Number) |
|                                      |   |                    |
| **9 Strathmore Road, Natick, MA**         |   | **01760**               |
| (Address  of principal executive offices) |   | (Zip  Code)             |

 

**(508)650-9971**

(Registrant’stelephone number, including area code)

 

**None**

(Formername, former address, and former fiscal year if changed since last report)

 

 

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

Yes  ý                   No  o

 

                Indicate by check mark whether the registrant is anaccelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes o                   No  ý

 

 

                Indicatethe number of shares outstanding of each of the issuer’s classes of commonstock, as of October 31, 2004.

 

| **Common Stock, par value of $.01** | ** ** | **30,947,363**      |
|-------------------------------------|------------|---------------------|
| (Title  of Class)                   |       | (Number  of Shares) |

 

 

 

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**VISION-SCIENCES,INC.**

**TABLEOF CONTENTS**

 
| Part I.  | Financial Information                                                                                | Page   |
|----------|------------------------------------------------------------------------------------------------------|--------|
|     |                                                                                                 |   |
|     | Item 1. Financial  Statements                                                                        |   |
|     |                                                                                                 |   |
|     | Consolidated Balance Sheets                                                                          | 3      |
|     |                                                                                                 |   |
|     | Consolidated  Statements of Operations                                                               | 4      |
|     |                                                                                                 |   |
|     | Consolidated  Statement of Stockholders’ Equity                                                 | 5      |
|     |                                                                                                 |   |
|     | Consolidated  Statements of Cash Flows                                                               | 6      |
|     |                                                                                                 |   |
|     | Notes to  Consolidated Financial Statements                                                          | 7-12   |
|     |                                                                                                 |   |
|     | Item  2. Management’s Discussion and Analysis of Financial Condition and Results of  Operations | 13-24  |
|     |                                                                                                 |   |
|     | Item  3. Quantitative and Qualitative Disclosures about Market Risk                                  | 24     |
|     |                                                                                                 |   |
|     | Item 4. Controls and  Procedures                                                                     | 25     |
|     |                                                                                                 |   |
| Part II. | Other Information                                                                                    |   |
|     |                                                                                                 |   |
|     | Item  4. Submission of Matters to a Vote of Stockholders                                             | 26     |
|     |                                                                                                 |   |
|     | Item 5. Other Information                                                                            | 26     |
|     |                                                                                                 |   |
|     | Item 6.  Exhibits and Reports on Form 8-K                                                            | 26     |
|     |                                                                                                 |   |
|     | Signatures                                                                                           | 27     |
|     |                                                                                                 |   |
|     | Exhibits                                                                                             | 28-30  |

 

 

2

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** **

**PART I - FINANCIAL INFORMATION**

**Item 1: FINANCIALSTATEMENTS**

 

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

**CONSOLIDATED BALANCESHEETS**

**(Unaudited)**

** **
| ** **                                                                                                   | ** ** | **September 30,** | ** ** | **March 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|---------------|------------|
| ** **                                                                                                   | ** ** | **2004**          | ** ** | **2004**      | ** ** |
| ASSETS                                                                                                       |       |
| Current Assets:                                                                                              |       |              |       |          |       |
| Cash and cash equivalents                                                                                    |       | $                 | 1,717,046  |          | $          | 2,714,941 |   |
| Accounts receivable, net of allowance for doubtful accounts of  $66,679 and $52,800, respectively            |       | 1,044,749         |       | 1,683,459     |       |
| Inventories                                                                                                  |       | 1,755,935         |       | 1,352,716     |       |
| Prepaid expenses and deposits                                                                                |       | 62,732            |       | 62,182        |       |
| Total current assets                                                                                         |       | 4,580,462         |       | 5,813,298     |       |
|                                                                                                         |       |              |       |          |       |
| Property and Equipment, at cost:                                                                             |       |              |       |          |       |
| Machinery and equipment                                                                                      |       | 3,896,553         |       | 3,623,854     |       |
| Furniture and fixtures                                                                                       |       | 242,071           |       | 212,002       |       |
| Leasehold improvements                                                                                       |       | 569,604           |       | 473,411       |       |
|                                                                                                         |       | 4,708,228         |       | 4,309,267     |       |
| Less-Accumulated depreciation and amortization                                                               |       | 3,849,405         |       | 3,728,242     |       |
|                                                                                                         |       | 858,823           |       | 581,025       |       |
|                                                                                                         |       |              |       |          |       |
| Advance to Three BY Ltd                                                                                      |       | 267,500           |       | 267,500       |       |
|                                                                                                         |       |              |       |          |       |
| Other assets, net of accumulated amortization of $50,614 and $47,428,  respectively                          |       | 78,002            |       | 66,751        |       |
| Total assets                                                                                                 |       | $                 | 5,784,787  |          | $          | 6,728,574 |   |
|                                                                                                         |       |              |       |          |       |
| LIABILITIES  AND STOCKHOLDERS’ EQUITY                                                                   |       |
| Current Liabilities:                                                                                         |       |              |       |          |       |
| Acceptances payable to a bank                                                                                |       | $                 | 56,144     |          | $          | 51,766 |   |
| Current portion of note payable                                                                              |       | 18,379            |       | 17,495        |       |
| Accounts payable                                                                                             |       | 697,248           |       | 681,998       |       |
| Accrued expenses                                                                                             |       | 852,974           |       | 970,755       |       |
| Total current liabilities                                                                                    |       | 1,624,745         |       | 1,722,014     |       |
|                                                                                                         |       |              |       |          |       |
| Long term portion of note payable                                                                            |       | 31,198            |       | 40,614        |       |
|                                                                                                         |       |              |       |          |       |
| Stockholders’ Equity:                                                                                   |       |              |       |          |       |
| Common stock, $.01 par value—                                                                           |       |              |       |          |       |
| Authorized—50,000,000 shares                                                                            |       |              |       |          |       |
| Issued and outstanding—30,942,463 shares at September 30, 2004 and  30,687,963 shares at March 31, 2004 |       | 309,424           |       | 306,879       |       |
| Additional paid-in capital                                                                                   |       | 65,016,725        |       | 64,649,956    |       |
| Accumulated deficit                                                                                          |       | (61,197,305       | )          | (59,990,889   | )          |
| Total stockholders’ equity                                                                              |       | 4,128,844         |       | 4,965,946     |       |
| Total liabilities and stockholders’ equity                                                              |       | $                 | 5,784,787  |          | $          | 6,728,574 |   |

 

 

See accompanying notes to consolidated financial statements.

 

3

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

**CONSOLIDATED STATEMENTS OFOPERATIONS**

**(Unaudited)**

** **
| ** **                                                           | ** ** | **Three Months Ended** | ** ** | **Six Months Ended**   | ** ** |
|----------------------------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                                           | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
| ** **                                                           | ** ** | **2004**               | ** ** | **2003**               | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net sales                                                            |       | $                      | 2,031,438  |                   | $          | 2,106,754 |   | $ | 4,808,219 |   | $ | 4,067,237 |   |
| Cost of sales                                                        |       | 1,780,599              |       | 1,304,769              |       | 3,474,815 |   | 2,507,666 |   |
|                                                                 |       |                   |       |                   |       |   |   |   |   |
| Gross profit                                                         |       | 250,839                |       | 801,985                |       | 1,333,404 |   | 1,559,571 |   |
|                                                                 |       |                   |       |                   |       |   |   |   |   |
| Selling, general and administrative expenses (1)                     |       | 844,622                |       | 936,327                |       | 1,841,057 |   | 1,807,752 |   |
| Research and development expenses (1)                                |       | 308,548                |       | 135,695                |       | 648,743 |   | 295,334 |   |
| Stock-based compensation                                             |       | 33,526                 |       | 579,235                |       | 67,052 |   | 634,988 |   |
| Loss from operations                                                 |       | (935,857               | )          | (849,272               | )          | (1,223,448 | ) | (1,178,503 | ) |
|                                                                 |       |                   |       |                   |       |   |   |   |   |
| Interest income                                                      |       | 7,389                  |       | 6,541                  |       | 16,074 |   | 14,713 |   |
| Interest expense                                                     |       | (1,298                 | )          | —                 |       | (2,701 | ) | — |   |
| Other income, net                                                    |       | —                 |       | 3,625                  |       | 3,659 |   | 7,236 |   |
|                                                                 |       |                   |       |                   |       |   |   |   |   |
| Net loss                                                             |       | $                      | (929,766   | )                      | $          | (839,106 | ) | $ | (1,206,416 | ) | $ | (1,156,554 | ) |
|                                                                 |       |                   |       |                   |       |   |   |   |   |
| Basic and diluted net loss per common share                          |       | $                      | (0.03      | )                      | $          | (0.03 | ) | $ | (0.04 | ) | $ | (0.04 | ) |
|                                                                 |       |                   |       |                   |       |   |   |   |   |
| Shares used in computing basic and diluted net loss per common share |       | 30,925,047             |       | 30,138,269             |       | 30,880,365 |   | 30,063,148 |   |
|                                                                      |            |                        |            |                        |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

 

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

 
| Research and development expenses            |   | $      | 109    |   | $      | 482,170 |   | $       | 219    |   | $ | 519,563 |   |
|----------------------------------------------|--------|--------|--------|--------|--------|---------|--------|---------|--------|--------|---|---------|--------|
| Selling, general and administrative expenses |   | 33,417 |   | 97,065 |   | 66,833  |   | 115,425 |   |
| Total                                        |   | $      | 33,526 |   | $      | 579,235 |   | $       | 67,052 |   | $ | 634,988 |   |

 

 

See accompanying notes to consolidated financial statements.

 

4

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

**CONSOLIDATED STATEMENT OFSTOCKHOLDERS’ EQUITY**

**(Unaudited)**

 
| ** **                                                                | ** ** | **Common Stock** | ** ** | ** **     | ** ** | ** **          | ** ** | ** **      | ** ** | ** **             | ** **  |
|---------------------------------------------------------------------------|------------|------------------|------------|----------------|------------|---------------------|------------|-----------------|------------|------------------------|-------------|
| ** **                                                                | ** ** | ** **       | ** ** | ** **     | ** ** | ** **          | ** ** | ** **      | ** ** | **Total**              | ** **  | **Total** | ** ** |
| ** **                                                                | ** ** | **Number of**    | ** ** | **$ .01** | ** ** | **Additional**      | ** ** | **Accumulated** | ** ** | **Stockholders’** | ** **  | **Comprehensive** | ** ** |
| ** **                                                                | ** ** | **Shares**       | ** ** | **Par Value**  | ** ** | **Paid-in-Capital** | ** ** | **Deficit**     | ** ** | **Equity**             | ** **  | **Loss** | ** ** |
|                                                                      |       |             |       |           |       |                |       |            |       |                   |        |   |   |
| Balance, March  31, 2004                                                  |       | 30,687,963       |       | $              | 306,879    |                | $          | 64,649,956      |       | $                      | (59,990,889 | ) | $ | 4,965,946 |   |   |   |
| Exercise of stock  options, net                                           |       | 254,500          |       | 2,545          |       | 299,717             |       | —          |       | 302,262                |        |   |   |
| Compensation  expense related to non-employee non-qualified stock options |       |             |       |           |       | 60,458              |       | —          |       | 60,458                 |        |   |   |
| Compensation  expense related to employee non-qualified stock options     |       |             |       |           |       | 6,594               |       |            |       | 6,594                  |        |   |   |
| Net loss                                                                  |       | —           |       | —         |       | —              |       | (1,206,416      | )          | (1,206,416             | )           | $ | (1,206,416 | ) |
| Total  comprehensive loss                                                 |       |             |       |           |       |                |       |            |       |                   |        | $ | (1,206,416 | ) |
| Balance September  30, 2004                                               |       | 30,942,463       |       | $              | 309,424    |                | $          | 65,016,725      |       | $                      | (61,197,305 | ) | $ | 4,128,844 |   |   |   |
|                                                                           |            |                  |            |                |            |                     |            |                 |            |                        |             |  |  |  |  |  |  |  |  |

 

 

See accompanying notes to consolidated financial statements.

 

5

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

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(Unaudited)**

 
| ** **                                                                                               | ** ** | **Six Months Ended**   | ** ** | **Six Months Ended**   | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                                                                               | ** ** | **September 30, 2004** | ** ** | **September 30, 2003** | ** ** |
| Cash flows from operating activities:                                                                    |       |                   |       |                   |       |
| Net loss                                                                                                 |       | $                      | (1,206,416 | )                      | $          | (1,156,554 | ) |
| Adjustments to reconcile net loss to net cash used for operating  activities:                            |       |                   |       |                   |       |
| Depreciation and amortization                                                                            |       | 124,349                |       | 107,827                |       |
| Stock compensation for non-qualified options                                                             |       | 67,052                 |       | 634,988                |       |
| Changes in assets and liabilities:                                                                       |       |                   |       |                   |       |
| Accounts receivable                                                                                      |       | 638,710                |       | (430,861               | )          |
| Inventories                                                                                              |       | (403,219               | )          | 52,959                 |       |
| Prepaid expenses and deposits                                                                            |       | (550                   | )          | 5,613                  |       |
| Accounts payable                                                                                         |       | 15,250                 |       | 178,400                |       |
| Accrued expenses                                                                                         |       | (117,781               | )          | 63,210                 |       |
| Net cash used for operating activities                                                                   |       | (882,605               | )          | (544,418               | )          |
|                                                                                                     |       |                   |       |                   |       |
| Cash flows used for investing activities                                                                 |       |                   |       |                   |       |
| Increase in marketable securities                                                                        |       | —                 |       | (2,014,283             | )          |
| Purchase of property and equipment, net                                                                  |       | (398,961               | )          | (50,633                | )          |
| Advance to Three BY Ltd.                                                                                 |       | —                 |       | (216,500               | )          |
| Increase in other assets                                                                                 |       | (14,437                | )          | —                 |       |
|                                                                                                     |       |                   |       |                   |       |
| Net cash used for investing activities                                                                   |       | (413,398               | )          | (2,281,416             | )          |
|                                                                                                     |       |                   |       |                   |       |
| Cash flows provided by (used for) financing activities:                                                  |       |                   |       |                   |       |
| Payments on note payable for computer equipment                                                          |       | (8,532                 | )          | —                 |       |
| Proceeds from acceptances payable to a bank                                                              |       | 4,378                  |       | 18,281                 |       |
| Proceeds from the sale of common stock, net                                                              |       | —                 |       | 329,012                |       |
| Exercise of stock options, net                                                                           |       | 302,262                |       | 110,061                |       |
| Net cash provided by financing activities                                                                |       | 298,108                |       | 457,354                |       |
| Net decrease in cash and cash equivalents                                                                |       | (997,895               | )          | (2,368,480             | )          |
| Cash and cash equivalents, beginning of period                                                           |       | 2,714,941              |       | 2,744,143              |       |
| Cash and cash equivalents, end of period                                                                 |       | $                      | 1,717,046  |                   | $          | 375,663 |   |
|                                                                                                     |       |                   |       |                   |       |
| Supplemental Disclosure of Cash Flow Information:                                                        |       |                   |       |                   |       |
| Cash paid during the period for interest                                                                 |       | $                      | 2,701      |                   | $          | — |   |
|                                                                                                     |       |                   |       |                   |       |
| Supplemental Disclosure of Non-cash Items from Financing Activities:                                     |       |                   |       |                   |       |
|                                                                                                     |       |                   |       |                   |       |
| Fair market value of non-qualified options granted in the period                                         |       | $                      | 241,832    |                   | $          | 1,411,550 |   |
|                                                                                                     |       |                   |       |                   |       |
| Change in the fair market value of non-qualified options existing at  the beginning of the period   |       | $                      | —     |                   | $          | 627,452 |   |

 

 

See accompanying notes to consolidated financial statements.

 

 

6

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

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**(Unaudited)**

 

 

**1**.                                      **Basisof Presentation**

The consolidated financialstatements included herein have been prepared by the Company in accordance withaccounting principles generally accepted in the United States of America,without audit, pursuant to the rules and regulations of the Securities andExchange Commission and include, in the opinion of management, all adjustments(consisting only of normal and recurring adjustments) that the Companyconsiders necessary for a fair presentation of such information.  Certain information and footnote disclosuresnormally included in financial statements have been condensed or omittedpursuant to such rules and regulations. The Company believes, however, that its disclosures are adequate to makethe information presented not misleading.  These consolidated financial statements shouldbe read in conjunction with the audited consolidated financial statements andnotes 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**.                                      **Summaryof Significant Accounting Policies**

 

The accompanyingconsolidated financial statements reflect the application of certain accountingpolicies 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,which approximates amortized cost*.** *Cash equivalents areshort-term, highly liquid investments with original maturities of less thanthree months.

 

c.                                       *MarketableSecurities*: Marketable securities are carried at market value,which approximates amortized cost.  TheCompany has classified its investments in marketable securities asavailable-for-sale securities.  AtSeptember 30, 2004, the Company had no marketable securities.

 

d.                                      *Inventories*: Inventoriesare stated at the lower of cost or market using the first-in, first-out (FIFO)method and consist of the following:

 
| ** **      | ** ** | **September 30,** | ** ** | **March 31,** | ** ** |
|-----------------|------------|-------------------|------------|---------------|------------|
| ** **      | ** ** | **2004**          | ** ** | **2004**      | ** ** |
| ** **      | ** ** | ** **        | ** ** | **(audited)** | ** ** |
| Raw materials   |       | $                 | 1,032,862  |          | $          | 726,221 |   |
| Work-in-process |       | 356,152           |       | 297,220       |       |
| Finished goods  |       | 366,921           |       | 329,275       |       |
|            |       | $                 | 1,755,935  |          | $          | 1,352,716 |   |

 

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

 

7

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e.                                       *Depreciationand Amortization*: The Company provides for depreciation and amortizationusing the straight-line method in amounts that allocate the cost of the assetsto operations over their estimated useful lives as follows:

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

 

Leasehold improvements areamortized over the shorter of their estimated useful lives or the lives of theleases.

 

f.                                         *Basicand Diluted Net Loss Per Common Share*: Basic and diluted net lossper common 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 Companyrecognizes revenue: (1) persuasive evidence of an arrangement exists, (2) deliveryhas occurred or services have been rendered, (3) the price is fixed ordeterminable, (4) collectibility is reasonably assured and (5) thefair value of undelivered elements, if any, exists.  Generally, the Company does not enter intomultiple element arrangements.  TheCompany follows EITF 01-9 to record the effect on sales of any rebatesoffered to customers.

 

h.                                      *ForeignCurrency Transactions*: In accordance with Statement of FinancialAccounting Standard (“SFAS”) No. 52, *Foreign CurrencyTranslation,* the Company charges foreign currency exchange gains orlosses, in connection with its purchases of products from vendors in Japan, tooperations, and charges foreign exchange translation gains and losses toretained earnings.

 

i.                                          *IncomeTaxes*: The Company accounts for income taxes under the liability method inaccordance with SFAS No. 109, *Accounting for IncomeTaxes*.  Under SFAS No. 109,deferred tax assets or liabilities are computed based upon the differencesbetween the financial statement and income tax bases of assets and liabilitiesas measured by the enacted tax rates.

 

TheCompany has recorded a valuation allowance equal to its net deferred tax assetdue to the uncertainty of realizing the benefit of this asset.

 

8

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j.                                          *Accounting for Derivative Instruments:*TheCompany accounts for non-qualified stock option agreements issued tonon-employees as equity instruments, in accordance with the provisions ofEmerging Issues Task Force (“EITF”) 96-18. In the three months ended June 30, 2004, the Company grantednon-qualified options to purchase 100,000 shares of the Company’s Common Stockto a consultant, with a value of approximately $241,832.  This value was determined using theBlack-Scholes option-pricing model.  TheCompany will recognize this amount in its operations ratably over a two-yearperiod, according to the vesting schedule of the option.  In the three and six months ended September 30,2004, the Company recognized $30,229 and $60,458, respectively of expense asstock-based compensation in the consolidated statement of operations.

k.                                       *Employee Stock-based Compensation Arrangements:*TheCompany accounts for its employee stock-based compensation arrangements usingthe intrinsic value method under the provisions of Accounting Principles BoardOpinion No. 25, *Accounting for StockIssued to Employees*, and Financial Interpretation No. (“FIN”) 44.  The Company does not recognize stock-basedemployee compensation cost when the options granted have an exercise priceequal to, or greater than, the market value of the underlying common stock onthe date of the grant.  The Company doesrecognize stock-based employee compensation cost when the options granted havean exercise price less than the market value of the underlying common stock onthe date of the grant.

In June 2003, theCompany granted options to purchase 1,295,000 shares of common stock to itsemployees at an exercise price of $1.04 per share.  The fair market value of the common stock onthe date of grant was $1.09 per share. As a result, the Company has recognized compensation expense for thedifference between the fair market value and the option price over the life ofthe options.  In the three and six monthsended September 30, 2004, the Company recognized $3,297 and $6,594,respectively of expense as stock-based compensation in the consolidated statementof operations.

 

9

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In accordance with theFinancial Accounting Standards Board (FASB) Statement No. 148, *Accounting for Stock-Based Compensation — Transition and Disclosure*,beginning in the quarter ending March 31, 2003, the Company adopted thedisclosure requirements of FASB No. 148. Had compensation expense for all stock option grants to employees beendetermined under the fair value method at the grant dates, consistent with themethod prescribed by SFAS No. 123, the Company’s net loss would have beenincreased to the pro forma amounts indicated as follows: 
| ** **                                           | ** ** | **Three Months Ended  September 30,** | ** ** | **Six Months Ended  September 30,** | ** ** |
|------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                           | ** ** | **2004**                              | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net loss — as reported                          |       | $                                     | (929,766   | )                                   | $          | (839,106 | ) | $ | (1,206,416 | ) | $ | (1,156,554 | ) |
| Stock-based employee compensation — as reported |       | 3,297                                 |       | 5,652                               |       | 6,594 |   | 7,536 |   |
| Pro forma stock-based employee compensation          |       | (103,500                              | )          | (69,000                             | )          | (198,000 | ) | (138,000 | ) |
| Net loss — pro forma                            |       | $                                     | (1,029,969 | )                                   | $          | (902,454 | ) | $ | (1,397,822 | ) | $ | (1,287,018 | ) |
|                                                 |       |                                  |       |                                |       |   |   |   |   |
| Net loss per share — as reported                |       | $                                     | (.03       | )                                   | $          | (.03 | ) | $ | (.04 | ) | $ | (.04 | ) |
| Stock-based employee compensation — as reported |       | —                                |       | —                              |       | — |   | — |   |
| Pro forma stock-based employee compensation          |       | —                                |       | —                              |       | (.01 | ) | — |   |
| Net loss per share — pro forma                  |       | $                                     | (.03       | )                                   | $          | (.03 | ) | $ | (.05 | ) | $ | (.04 | ) |

 

**3.****                                     ****Three BY Ltd.**

 

In June 2003, theCompany entered into a Contract Manufacturing Agreement, a Loan Agreement and aPledge Agreement (collectively, the “3BY Agreements”) with Three BY Ltd., anIsraeli company (“3BY”).  The 3BY Agreementsprovide for, among other things, the manufacture of certain of the Company’sproducts by 3BY, and a loan of up to $267,500 by the Company to 3BY for thepurchase and installation of certain manufacturing equipment by 3BY, at 3BY’sfacility, to be used to manufacture certain of the Company’s products.  As of December 31, 2003, the Company hadadvanced the complete loan.  3BY hascompleted the purchase and installation of the manufacturing equipment, and theCompany began receiving commercial production from 3BY in the three monthsending September 30, 2004.  The Companyplans to take title to the manufacturing equipment and convert the advance tomachinery and equipment in the three months ending December 31, 2004.

 

10

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**4.****                                     ****Segment Information**

 

The Company has threereportable segments — medical, industrial and corporate.  The medical segment designs, manufactures andsells 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.

 

All segments follow theaccounting policies described in the summary of significant accountingpolicies.  The Company evaluates segmentperformance based upon operating income. Identifiable assets are those used directly in the operations of eachsegment.  Corporate assets include cash,marketable securities and the assets of Vision-Sciences, Ltd.  Data regarding management’s view of theCompany’s segments are provided in the following tables.

 

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| **Three months ended September 30,** | ** ** | **Medical** | ** ** | **Industrial** | ** ** | **Corporate** | ** ** | **Adjustments** | ** ** | **Total** | ** ** |
|--------------------------------------|------------|-------------|------------|----------------|------------|---------------|------------|-----------------|------------|-----------|------------|
| **2004**                             |       |        |       |           |       |          |       |            |       |      |       |
| Sales to external customers          |       | $           | 1,130,315  |           | $          | 901,123       |       | $               | —     |      | $          | — |   | $ | 2,031,438 |   |
| Intersegment sales                   |       | —      |       | 330,253        |       | —        |       | (330,253        | )          | —    |       |
| Operating income (loss)              |       | (615,701    | )          | (51,737        | )          | (268,419      | )          | —          |       | (935,857  | )          |
| Interest income (expense), net       |       | —      |       | —         |       | 6,091         |       | —          |       | 6,091     |       |
| Depreciation and amortization        |       | 54,386      |       | 11,596         |       | 1,506         |       | —          |       | 67,488    |       |
| Advance to 3BY Ltd.                  |       | —      |       | —         |       | —        |       | —          |       | —    |       |
| Other significant non-cash items:    |       |        |       |           |       |          |       |            |       |      |       |
| Stock-based compensation             |       | 30,416      |       | 63             |       | 3,047         |       | —          |       | 33,526    |       |
| Expenditures for fixed assets        |       | 227,078     |       | 17,491         |       | —        |       | —          |       | 244,569   |       |
|                                 |       |        |       |           |       |          |       |            |       |      |       |
| **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), net       |       | —      |       | —         |       | 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    |       |

 
| **Six months ended September 30,** | ** ** | **Medical** | ** ** | **Industrial** | ** ** | **Corporate** | ** ** | **Adjustments** | ** ** | **Total**  | ** ** |
|------------------------------------|------------|-------------|------------|----------------|------------|---------------|------------|-----------------|------------|------------|------------|
| **2004**                           |       |        |       |           |       |          |       |            |       |       |       |
| Sales to external customers        |       | $           | 3,107,645  |           | $          | 1,700,574     |       | $               | —     |       | $          | — |   | $ | 4,808,219 |   |
| Intersegment sales                 |       | —      |       | 977,214        |       | —        |       | (977,214        | )          | —     |       |
| Operating income (loss)            |       | (605,442    | )          | (31,443        | )          | (586,563      | )          | —          |       | (1,223,448 | )          |
| Interest income (expense), net     |       | —      |       | —         |       | 13,373        |       | —          |       | 13,373     |       |
| Depreciation and amortization      |       | 98,769      |       | 22,568         |       | 3,012         |       | —          |       | 124,349    |       |
| Advance to 3BY Ltd.                |       | —      |       | —         |       | —        |       | —          |       | —     |       |
| Other significant non-cash items:  |       | —      |       | —         |       | —        |       | —          |       | —     |       |
| Stock-based compensation           |       | 60,832      |       | 126            |       | 6,094         |       | —          |       | 67,052     |       |
| Expenditures for fixed assets      |       | 376,811     |       | 22,150         |       | —        |       | —          |       | 398,961    |       |
| Total assets                       |       | 2,664,864   |       | 1,594,733      |       | 1,806,008     |       | (280,818        | )          | 5,784,787  |       |
|                               |       |        |       |           |       |          |       |            |       |       |       |
| **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), net     |       | —      |       | —         |       | 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  |       |
|                                    |            |             |            |                |            |               |            |                 |            |            |            |  |  |  |  |  |  |

 

 

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## **Item2.  MANAGEMENT’S DISCUSSION AND ANALYSISOFFINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

**Executive Summary**

 

This Quarterly Report onForm 10-Q contains forward-looking statements within the meaning of The PrivateSecurities Litigation Reform Act of 1995. Examples of forward-looking statements include statements aboutexpectations about future financial results, future products and future salesof new and existing products, future expenditures, and capital resources tomeet anticipated requirements.  Withoutlimiting the foregoing, the words “believes”, “anticipates”, “plans”, “expects”,and similar expressions are intended to identify forward-lookingstatements.  These forward-lookingstatements involve risks and uncertainties, and our actual results may differsignificantly from those discussed in the forward-looking statements. Factorsthat might cause such a difference include, but are not limited to, theavailability of capital resources, the availability of third-partyreimbursement, government regulation, the availability of supplies,competition, technological difficulties, the continuation of our contract withMedtronic Xomed, Inc., general economic conditions and other risks detailed inour most recent Annual Report on Form 10-K and any subsequent periodic filingsmade 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 flexibleendoscope products for the medical device and industrial device markets.  We operate in three reporting segments,medical, industrial and corporate.

 

#### *Medical Segment*

 

The medical segment supplies flexibleendoscopes and disposable Slide-OnTM EndoSheath® Systems (“EndoSheaths”) to theEar-Nose-Throat (“ENT”), gastrointestinal (“GI”), urology and pulmonarymarkets.  Health-care providers useEndoSheaths to cover the insertion tube of flexible endoscopes, such as ENTendoscopes, Trans-Nasal Esophagoscopes (“TNE”), sigmoidoscopes, cystoscopes andbronchoscopes.  We have designed theEndoSheaths to allow the health-care providers to process patients economicallyby permitting the providers to minimize reprocessing the endoscopes betweenprocedures.  In addition, the EndoSheathsensure a sterile insertion tube for each patient procedure.

 

Our strategy in the medical segment iscomprised of three components: a) improve sales distribution, b) lowermanufacturing costs and c) increase the number of new product offerings.

 

#### *SalesDistribution*

 

Since September 19, 2003 we have beendistributing all of our products for the ENT markets in the U.S.A. and Canadathrough Medtronic Xomed, Inc. (“Medtronic Xomed”) as part of our exclusivedistribution agreement (the “Medtronic Agreement”) with them. The initial termof the Medtronic Agreement is three years. Thereafter, the Medtronic Agreement will be automatically renewed forsuccessive one-year periods, unless terminated by either party upon advancewritten notice.  Under the MedtronicAgreement, we have granted Medtronic Xomed exclusive distribution rights in theUnited States and Canada to market and sell our ENT EndoSheaths, ENT endoscopesTNE endoscopes and TNE EndoSheaths to ENT practitioners.  As of July 2004 Medtronic Xomed completed theminimum purchase requirements for the initial twelve-month period of the term,ending in August 2004 (“Year 1”).

 

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Under the Medtronic Agreement, in order tomaintain its exclusive distribution rights, Medtronic Xomed is required topurchase at least 110% of the Year 1 unit volume of ENT EndoSheaths in Year2.  Due to higher than expected inventorylevels of ENT EndoSheaths at Medtronic Xomed at the end of Year 1, MedtronicXomed is forecasting to purchase approximately 20,000 units of ENT EndoSheathsduring the remaining six months of our fiscal year ending March 31, 2005 (“FY05”), compared to approximately 125,800 units purchased by Medtronic Xomed inthe first six months of FY 05.  IfMedtronic Xomed continues to sell units to end users at their current rate,they would purchase significantly less ENT EndoSheaths from us than requiredunder the Agreement to maintain exclusivity. There can be no assurance that Medtronic Xomed will purchase therequired units to maintain exclusivity. As a result of the Medtronic Agreement, the success of our ENT product lines in thedomestic market is substantially dependent upon the success of the marketingand sales activities of Medtronic Xomed over which we have limitedcontrol.  We continue to market and sellour GI and Urology product lines directly to those markets, and we haveretained our own international network of distributors for all our medicalproduct lines.

 

#### *CostReduction*

 

During FY 04 we decided we could reducemanufacturing costs by sub-contracting the manufacture of our EndoSheaths forthe GI and ENT markets to 3BY, Ltd. (“3BY”), a company in Israel.  We realized a benefit of approximately$42,000 in the three months ended September 30, 2004 as we sold the firstcommercial lots of sigmoidoscope EndoSheaths that were manufactured by3BY.  We also received our firstcommercial lots of ENT EndoSheaths from 3BY, and will realize a benefit fromshipping those EndoSheaths in the three months ending December 31, 2004.  We are no longer manufacturing ENTEndoSheaths in our Natick facility.

 

#### *NewProducts*

 

In FY 04 we received clearance from the U.S.Food and Drug Administration, (“FDA”) to market a number of new products to theENT market.  In general, we designed theseproducts to allow the ENT physician to perform procedures in their offices,using their standard laryngoscopes, as opposed to the current practice oftraveling to hospitals to use special ENT endoscopes to perform the procedures.  Under the current reimbursement procedures ofthe Centers for Medicare & Medicaid Services (“CMS”), a governmental agencyunder the U.S. Department of Health and Human Services, ENT physicians willreceive higher reimbursements by performing the procedures in their offices thanthey receive when they perform them in a hospital.

 

In April 2004 we received clearance from theFood & Drug Administration to market our Flexible Cystoscope with Slide-OnEndoSheath System, and plan to continue to introduce products during the twelvemonths ending March 31, 2005 (“FY 05”) that enhance the practice efficiency ofphysicians and also ensure a sterile insertion tube for each patient procedure.

 

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#### *Industrial Segment*

 

The industrial segment designs, manufacturesand sells flexible endoscopes, termed borescopes, for industrial users, andmanufactures and repairs flexible endoscopes for the medical segment.  The industrial segment users consistprimarily of companies in the aircraft engine manufacturing and maintenancemarkets and the defense market.

 

#### *Corporate Segment*

 

The corporate segment consists of certainadministrative and business development activities applicable to the company asa whole.

 

Critical Accounting Policies and Estimates

 

Thisdiscussion and analysis of our financial condition and results of operations isbased upon our Consolidated Financial Statements, which have been prepared inaccordance with accounting principles generally accepted in the United States.  See the Notes to the Consolidated FinancialStatements included elsewhere herein. Certain of our accounting policies require the application of judgmentin selecting the appropriate assumptions for calculating financial estimates.  By their nature these judgments are subjectto an inherent degree of uncertainty.  Weperiodically evaluate the judgments and estimates used for our criticalaccounting policies to ensure that such judgments and estimates are reasonablefor 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 thefollowing:

 

### *RevenueRecognition*

 

We recognize revenue in accordance with SECStaff Accounting Bulletin No. 104, *Revenue Recognition inFinancial Statements*(SAB 104) and EITF 00-21, *Revenue Arrangements with Multiple Deliverables.* Thesepronouncements require that five basic criteria must be met before revenue canbe recognized: (1) persuasive evidence that an arrangement exists;(2) delivery has occurred or services rendered; (3) the fee is fixedand determinable; (4) collectibility is reasonably assured and (5) thefair value of undelivered elements, if any, exists.  Determination of criterion (4) is based onmanagement’s judgment regarding the collectibility of invoices for products andservices delivered to customers.  Shouldchanges in conditions cause management to determine these criteria are not metfor certain future transactions, revenue recognized for any reporting periodcould be adversely affected.

 

We recognize revenue in accordance with EITF 01-9,*Accounting for Consideration Given by a Vendor to aCustomer (Including a Reseller of the Vendor’s Products)*.  This pronouncement requires that a vendorrecognize rebates as a reduction of revenue based on a systematic and rationalallocation of the cost of honoring rebates earned and claimed to each of theunderlying revenue transactions that result in progress by the customer towardearning the rebate.  Measurement of thetotal rebate is based on the

 

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estimated number of customers that willultimately earn rebates under the offer. Determination of the number of customers that will earn rebates and theamount of those rebates is based on management’s judgment.  If different conditions result from thoseassumptions used in our judgment, the results could be materially differentfrom our estimates.

 

# ***Non-qualified Options Issued toNon-employees***

 

Effective March 31, 2004, we account fornon-qualified options issued to non-employees as equity instruments, inaccordance with the provisions of EITF 96-18.  Fair values for these non-qualified optionsare derived from pricing models that consider current market and contractualprices for the underlying financial instruments, as well as time value, yieldcurve and volatility factors underlying the positions.  Pricing models and their underlyingassumptions impact the amount and timing of the value of these non-qualifiedoptions, and the use of different pricing models or assumptions could producedifferent financial results.  We use theBlack-Scholes option-pricing model for determining the value of non-qualifiedoptions issued to non-employees, and we expense that value over the vestingperiod of the non-qualified options.

 

We account for certain non-qualified optionsgranted to employees to purchase 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 vesting period of the options.

 

*Income Taxes*

 

Under our income tax policy, we record theestimated future tax effects of temporary differences between the tax bases ofassets and liabilities and amounts recorded in the accompanying consolidatedbalance sheets, as well as operating loss and tax credit carryforwards.  The evaluation of the recoverability of anytax assets recorded on the balance sheet is subject to significantjudgment.  We have provided valuationallowances for all our deferred tax assets to date.

 

**Results of Operations**

 

Net Sales

*Q2 05 Compared to Q2 04*

Net sales for the threemonths ended September 30, 2004 (“Q2 05”) were $2,031,438, a decrease of$75,316, or 4%, compared to the three-month period ended September 30,2003 (“Q2 04”).  During Q2 05, net salesof the medical segment decreased by $269,283, or 19%, to $1,130,315, and netsales of the industrial segment increased by $193,967, or 27%, to $901,123,compared to Q2 04.  In the medicalsegment, the net sales and changes in net sales by market were as follows ($000’s):

 

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| **Market** | ** ** | ** ** | **Q2 05** | ** ** | **Q2 04** | ** ** | **Increase  (Decrease)** | ** ** | **Percent** | ** ** |
|------------|------------|------------|-----------|------------|-----------|------------|--------------------------|------------|-------------|------------|
| ENT        |       | $          | 910       |       | $         | 1,174      |                     | $          | (264        | )          | (22 | )% |
| GI         |       | 77         |      | 146        |      | (69        | )                        | (47        | )%          |
| Urology    |       | 72         |      | —     |      | 72         |                     | 100        | %           |
| Pulmonary  |       | —     |      | 19         |      | (19        | )                        | (100       | )%          |
| Other      |       | 71         |      | 61         |      | 10         |                     | 16         | %           |
| Total      |       | $          | 1,130     |       | $         | 1,400      |                     | $          | (270        | )          | (19 | )% |

 

*Medical Sales — ENT Market*

 

Net sales to the ENT market include productsfor domestic and international customers as follows:

 
| **ENT Market** | ** ** | ** ** | **Q2 05** | ** ** | **Q2 04** | ** ** | **Increase  (Decrease)** | ** ** | **Percent** | ** ** |
|----------------|------------|------------|-----------|------------|-----------|------------|--------------------------|------------|-------------|------------|
| Domestic       |       | $          | 560       |       | $         | 712        |                     | $          | (152        | )          | (21 | )% |
| International  |       | 350        |      | 462        |      | (112       | )                        | (24        | )%          |
| Total ENT      |       | $          | 910       |       | $         | 1,174      |                     | $          | (264        | )          | (22 | )% |
|                |            |            |           |            |           |            |                          |            |             |            |  |  |  |  |

 

We further delineate products sold to thedomestic ENT market as follows:

 
| **ENT Products**     | ** ** | ** ** | **Q2 05** | ** ** | **Q2 04** | ** ** | **Increase  (Decrease)** | ** ** | **Percent** | ** ** |
|----------------------|------------|------------|-----------|------------|-----------|------------|--------------------------|------------|-------------|------------|
| Slide-On EndoSheaths |       | $          | 261       |       | $         | 486        |                     | $          | (225        | )          | (46 | )% |
| Endoscopes           |       | 291        |      | 220        |      | 71         |                     | 32         | %           |
| Other products       |       | 8          |      | 6          |      | 2          |                     | 33         | %           |
| Total Domestic       |       | $          | 560       |       | $         | 712        |                     | $          | (152        | )          | (21 | )% |
|                      |            |            |           |            |           |            |                          |            |             |            |  |  |  |  |

## ** **

The primary reason for the decrease in netsales of ENT products to the domestic market was the completion in July 2004 byMedtronic Xomed of its minimum purchase requirements for Year 1 of the MedtronicAgreement.  As a result, Medtronic Xomedhad higher than expected levels of inventory of ENT endoscopes and ENT Slide-OnEndoSheaths (“ENT SOS”) at July 31, 2004, and did not purchase any of thoseproducts in August and September 2004. Although we do expect to sell these products to Medtronic Xomed duringthe third and fourth quarters of FY 05, we expect these sales will be at asignificantly slower rate than during the third and fourth quarters of FY04.  The lower sales of these productswere partially offset by the purchase by Medtronic Xomed of new products,including our diagnostic Trans-Nasal Esophagoscope (“TNE D”), our new ENT-1000small diameter flexible endoscope and companion EndoSheaths for theseendoscopes.

 

As a result of continuing discussions betweenus and Medtronic Xomed, we have initiated three programs designed to increasethe rate of sale of ENT SOS.  MedtronicXomed has assumed responsibility for two of these programs, and we have assumedresponsibility for a third one with them, a rebate program.  As part of this rebate program we will grantMedtronic Xomed a cash rebate for sales of ENT SOS to new users who commit tolarge annual purchases of ENT SOS.  Therebate program is designed to continue for one year, will be renewable by mutualagreement and will vary with the price charged by Medtronic Xomed to individualusers.  We are accounting for this rebateprogram under

 

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provisions of EITF 01-9, whereby for thethree months ended September 30, 2004 we reduced sales by approximately $39,000for the estimated potential rebate to be granted to Medtronic Xomed for salesby Medtronic Xomed after September 1, 2004 of ENT SOS that they had paid for,and were in their inventory on September 30, 2004.

 

We expect Medtronic Xomed to purchaseapproximately 20,000 units of ENT SOS during the third and fourth quarters ofFY 05, for which we will record a sales reduction for the estimatedrebate.  The amount to be rebated isbased upon a sliding scale that ranges from $.02 to $1.17 per ENT SOS, or 0.3%to 19.0% of our standard unit price to Medtronic Xomed.

 

Under the Medtronic Agreement, in order tomaintain its exclusive distribution rights, Medtronic Xomed is required topurchase at least 110% of the Year 1 unit volume of ENT EndoSheaths in Year2.  There can be no assurance, however,that Medtronic Xomed will decide to maintain its exclusive distributionrights.  As a result of the MedtronicAgreement, the success of our domestic ENT product lines will continue to besubstantially dependent upon the success of the marketing and sales activitiesof Medtronic Xomed, over which we have limited control.

 

Sales of the TNE D and ENT-1000 endoscopesand companion EndoSheaths totaled approximately $224,000 in Q2 05, and weexpect unit and dollar sales of these products will be higher in the third andfourth quarters of FY 05, as we expect to benefit from Medtronic Xomed’sefforts to penetrate the market for these products.

 

We also expect to release new products,including our therapeutic TNE (“TNE Bx”) and Slide-On EndoSheath System.  Both the TNE D and TNE Bx are productsdesigned to simplify the procedure, to increase the patient throughput and toallow ENT physicians to perform procedures in their offices using topicalanesthetics, compared to having to perform the same procedures in hospitalswhere patients are consciously sedated. Being able to see more patients, and under reimbursement proceduresallowed by CMS, physicians can generate more revenue by performing theseprocedures in their offices, compared to in a hospital environment.  The reimbursement rates are greater for thephysician, but less overall, as there is no reimbursement for the hospital.  Patients benefit also, as they avoid beingconsciously sedated and they experience the procedures with an insertion tubecovered with our sterile EndoSheath. These are new procedures for ENT physicians, and communicating thebenefits of them to the ENT physician is time-consuming.  We believe our relationship with MedtronicXomed is critical to the marketing and distribution process, as Medtronic Xomedpossesses greater sales and marketing abilities than we have.

 

We further delineate products sold to theinternational ENT market as follows:

 
| **ENT Products**     | ** ** | ** ** | **Q2 05** | ** ** | **Q2 04** | ** ** | **Increase  (Decrease)** | ** ** | **Percent** | ** ** |
|----------------------|------------|------------|-----------|------------|-----------|------------|--------------------------|------------|-------------|------------|
| Slide-On EndoSheaths |       | $          | 237       |       | $         | 347        |                     | $          | (110        | )          | (32 | )% |
| Endoscopes           |       | 113        |      | 115        |      | (2         | )                        | (2         | )%          |
| Other products       |       | —     |      | —     |      | —     |                     | —     | %           |
| Total International  |       | $          | 350       |       | $         | 462        |                     | $          | (112        | )          | (24 | )% |
|                      |            |            |           |            |           |            |                          |            |             |            |  |  |  |  |  |  |

 

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The decrease in net sales to internationaldistributors is primarily due to lower unit volume of ENT SOS, offset partiallyby higher unit average selling prices. Effective April 1, 2004 we increased prices approximately 8% for ENTSOS and 5% for ENT endoscopes.  Unitsales of ENT SOS to the international distributors were 36,214 in Q2 05, adecrease of 22,346 units, compared to sales in Q2 04.  Included in the units sold in Q2 05 were 200units for the ENT-1000 endoscope, not available for sale in Q2 04.  The lower demand from our distributors inEurope was partially offset by higher demand from our distributor inAustralia.  Some of this slower demand wasdue to seasonal factors and also to reduced purchasing power by medical facilitiesthat had overspent in other areas of their budget.  We expect unit demand in Europe will recover,but there can be no assurance it will recover to the level experienced in FY 04.

 

Unit sales of ENT endoscopes in Q2 05 tointernational distributors were 27, compared to 33 in Q2 04.  Unit sales in Q2 05 included 10 units of theENT-1000, not available for sale in Q2 04. Sales of ENT endoscopes are dependent upon a variety of factors,including the timing requirements of end users, foreign exchange rates, salespromotions of international competitors and other factors.  During FY 05 we increased our marketingefforts by hosting symposiums for physicians where they can experience thebenefits that our products can have on the efficiency of their practices andthe protection our products offer patients.

 

In addition, we plan to continue to signagreements favorable to us with distributors in countries where we do not havea presence.  However, there can be noassurance we will be able to consummate these agreements on terms that arebeneficial to us.

 

*Medical Sales — OtherMarkets*

 

Net sales to the GI market declined in Q2 05,compared to Q2 04, due primarily to lower demand for our proprietarysigmoidoscope EndoSheaths due to the aging of the installed base of oursigmoidoscopes and the continued insufficiency of reimbursement rates tophysicians to support the use of the products. We expect this decline to continue during FY 05.

 

During Q1 05 we launched our new FlexibleCystoscope (“CST-2000”) with Slide-On EndoSheath System at the AmericanUrological Association trade show.  In Q205, we shipped our CST-2000 endoscope and EndoSheaths to internationaldistributors in the U.K., Australia and Scandinavia.  We believe the CST-2000 and EndoSheath Systemcan significantly enhance the practice efficiency of urologists by allowingthem to avoid the tedious and time-consuming reprocessing of conventionalcystoscopes, and presents the significant benefit of a sterile insertion tubefor each patient.  In addition, the useof our CST-2000 with Slide-On EndoSheath System avoids the need to reprocessendoscopes with harsh chemicals, one of which has been contraindicated for useon patients with bladder cancer.

 

*Industrial Segment*

The increase in net sales of the industrialsegment was due to higher demand for new borescopes, offset partially by lowerdemand for repairs of borescopes.

 

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*6 Months 05 Compared to 6 Months04*

Net sales for the six months ended September 30,2004 (“6M 05”) were $4,808,219, an increase of $740,982, or 18%, compared tothe six-month period ended September 30, 2003 (“6M 04”).  During 6M 05 net sales of the medical segmentincreased by $437,030, or 16% to $3,107,645, and net sales of the industrialsegment increased by $303,952, or 22%, to $1,700,574, compared to 6M 04.  In the medical segment net sales and changesin net sales by market were as follows ($000’s):

 
| **Market** | ** ** | ** ** | **6M 05** | ** ** | **6M 04** | ** ** | **Increase  (Decrease)** | ** ** | **Percent** | ** ** |
|------------|------------|------------|-----------|------------|-----------|------------|--------------------------|------------|-------------|------------|
| ENT        |       | $          | 2,642     |       | $         | 2,232      |                     | $          | 410         |       | 18 | % |
| GI         |       | 171        |      | 298        |      | (127       | )                        | (43        | )%          |
| Urology    |       | 95         |      | —     |      | 95         |                     | 100        | %           |
| Pulmonary  |       | 6          |      | 32         |      | (26        | )                        | (81        | )%          |
| Other      |       | 194        |      | 109        |      | 85         |                     | 78         | %           |
| Total      |       | $          | 3,108     |       | $         | 2,671      |                     | $          | 437         |       | 16 | % |
|            |            |            |           |            |           |            |                          |            |             |            |  |  |  |  |  |

 

*Medical Sales — ENT Market*

 

Sales to the ENT market include products fordomestic and international customers as follows:

 
| **ENT Market** | ** ** | ** ** | **6M 05** | ** ** | **6M 04** | ** ** | **Increase  (Decrease)** | ** ** | **Percent** | ** ** |
|----------------|------------|------------|-----------|------------|-----------|------------|--------------------------|------------|-------------|------------|
| Domestic       |       | $          | 1,679     |       | $         | 1,180      |                     | $          | 499         |       | 42 | % |
| International  |       | 963        |      | 1,052      |      | (89        | )                        | (8         | )%          |
| Total ENT      |       | $          | 2,642     |       | $         | 2,232      |                     | $          | 410         |       | 18 | % |
|                |            |            |           |            |           |            |                          |            |             |            |  |  |  |  |

 

We further delineate products sold to thedomestic ENT market as follows:

 
| **ENT Products**     | ** ** | ** ** | **6M 05** | ** ** | **6M 04** | ** ** | **Increase  (Decrease)** | ** ** | **Percent** | ** ** |
|----------------------|------------|------------|-----------|------------|-----------|------------|--------------------------|------------|-------------|------------|
| Slide-On EndoSheaths |       | $          | 944       |       | $         | 893        |                     | $          | 51          |       | 6 | % |
| Endoscopes           |       | 627        |      | 287        |      | 340        |                     | 118        | %           |
| Other products       |       | 108        |      | —     |      | 108        |                     | 100        | %           |
| Total Domestic       |       | $          | 1,679     |       | $         | 1,180      |                     | $          | 499         |       | 42 | % |
|                      |            |            |           |            |           |            |                          |            |             |            |  |  |  |  |  |

 

Net sales of ENT SOS were strong in the sixmonths ended September 30, 2004, because during the fiscal quarter ended June30, 2004 Medtronic Xomed made significant purchases under the MedtronicAgreement.  These purchases declinedthereafter, as explained above.  Theincrease in net sales of endoscopes for the period reflects net sales in Q2 05of our TNE D endoscope and our ENT-1000 endoscope, offset partially by lowernet sales of our ENT-2000 endoscope to Medtronic Xomed, as discussedabove.  The increase in net sales ofother products reflects sales of products to ENT physicians for the diagnosisof swallowing disorders.

 

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We further delineate products sold to theinternational ENT market as follows:

 
| **ENT Products**     | ** ** | ** ** | **6M 05** | ** ** | **6M 04** | ** ** | **Increase  (Decrease)** | ** ** | **Percent** | ** ** |
|----------------------|------------|------------|-----------|------------|-----------|------------|--------------------------|------------|-------------|------------|
| Slide-On EndoSheaths |       | $          | 754       |       | $         | 831        |                     | $          | (77         | )          | (9 | )% |
| Endoscopes           |       | 209        |      | 221        |      | (12        | )                        | (5         | )%          |
| Total International  |       | $          | 963       |       | $         | 1,052      |                     | $          | (89         | )          | (8 | )% |
|                      |            |            |           |            |           |            |                          |            |             |            |  |  |  |  |

 

The lower net sales of ENT SOS and endoscopesto the international market were due primarily to the results of Q2 05, asexplained above.

 

*Industrial Segment*

 

The increase in net sales for the 6M 05compared to 6M 04 was due to higher demand in Q2 05 for new borescopes.

 

Gross Profit

*Q2 05 Compared to Q2 04*

Gross profit was $250,839 in Q2 05, adecrease of $551,146, compared to gross profit in Q2 04.  Gross profit decreased by approximately$493,000 in the medical segment, and by approximately $58,000 in the industrialsegment.  The decrease in gross profit inthe medical segment was due primarily to the lower unit volume of the ENT SOSand lower average selling prices of the ENT SOS, due to prices in the MedtronicXomed agreement being lower than when we distributed these products through ourown independent sales representative organization.  In addition, we recorded an accrued rebate toMedtronic Xomed.  The medical segmentrecorded an increase in gross profit due to sales of TNE D endoscopes andcystoscopes, but this was offset partially by higher production costs normallyincurred with the initial production of new EndoSheaths.  The medical segment also recorded highergross profit on the sale of EndoSheaths to the GI market, due to the lowercosts of production of these EndoSheaths by 3BY Ltd., our subcontractor inIsrael.  The medical segment received itsfirst production lots of ENT SOS from 3BY in Q2 05, and will benefit from thelower costs of production of the ENT SOS in the three months ending December31, 2004.  In the industrial segment, thedecrease in gross profit was due primarily to an increase in overheadproduction costs.

 

In FY 04, we began the process of moving themanufacturing of our EndoSheaths to 3BY Ltd, a sub-contractor in Israel, tofurther reduce the manufacturing cost of these products.  We advanced $267,500 to the sub-contractorfor the purchase and installation of machinery to produce ENT EndoSheaths.  We received the first commercial shipments ofthese products in the three months ending September 30, 2004.  We expect to produce a lower quantity of ENTSOS in FY 05 than we had planned, increasing the risk associated with repaymentof the advance.  To eliminate this riskand to secure title to this equipment, we plan to take ownership of theequipment in the three months ending December 31, 2004.

 

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*6M 05 Compared to 6M 04*

The reduction in gross profit for the 6M 05compared to 6M 04 was due primarily to the lower gross profit in Q2 05, asexplained above.

 

Operating Expenses

 

*Selling, General andAdministrative Expenses*

 

*Q2 05 Compared to Q2 04*

The decrease in selling, general andadministrative (“SG&A”) expenses in Q2 05 was due primarily to lowerspending for legal and professional fees in the medical segment.

 

*6M 05 Compared to 6M 04*

The increase in S,G&A expenses for the 6M05 compared to 6M 04 was due primarily to higher marketing and promotion costsrelated to launching new products.

 

*Research and DevelopmentExpenses*

 

*Q2 05 Compared to Q2 04*

The increase in R&Dexpenses in Q2 05, compared to Q2 04 was due primarily to additional spendingfor materials and personnel hired to work on developing new products for themedical segment.  We expect costs for R&Dwill continue to be higher in FY 05, compared to FY 04, as we increase ourefforts to develop new products utilizing the technology inherent in ourEndoSheaths.

 

*6M 05 Compared to 6M 04*

The increase in R&Dexpenses for 6M 05, compared to 6M 04 was due primarily to the same reasons asexplained above.

 

*Stock-basedCompensation Expenses*

 

We incurred stock-basedcompensation costs during Q1 05 and Q2 05, due primarily to the grant in April2004 of a non-qualified option to purchase 100,000 shares of our Common Stockto an outside consultant.  This grant wasin accordance with an agreement entered into with that consultant in January2003.  The value of the non-qualifiedoption was determined to be approximately $242,000, using the Black-Scholesoption-pricing model, and will be recorded in our statements of operations overthe vesting period of the option.  Ineach of Q1 05 and Q2 05, we recorded approximately $30,000 of expense relatedto this non-qualified option in our statements of operations.  In addition, during the three months endedJune 30, 2003, the compensation committee of our board of directors authorizedthe issuance of non-qualified options to purchase 1,295,000 shares of commonstock to certain of our employees.  Theseoptions were priced below the fair market price of our common stock on the dateof grant.  Accordingly, we will recognizecompensation expense totaling approximately $65,000 from June 2003 throughDecember 2007, the vesting period of these options.  In each of Q1 05 and Q2 05, we incurredapproximately $3,000 of expense for these options in our statements ofoperations.

 

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Operating Income (Loss)

 

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

 
| **Segment** | ** ** | ** ** | **Q2 05** | ** ** | **Q2 04** | ** ** | **Change** | ** ** | **6M 05** | ** ** | **6M 04** | ** ** | **Change** | ** ** |
|-------------|------------|------------|-----------|------------|-----------|------------|------------|------------|-----------|------------|-----------|------------|------------|------------|
| Medical     |       | $          | (616      | )          | $         | 17         |       | $          | (633      | )          | $         | (605       | )          | $          | 41 |   | $ | (646 | ) |
| Industrial  |       | (52        | )         | 4          |      | (56        | )          | (31        | )         | (21        | )         | (10        | )          |
| Corporate   |       | (268       | )         | (870       | )         | 602        |       | (587       | )         | (1,198     | )         | 611        |       |
| Total       |       | $          | (936      | )          | $         | (849       | )          | $          | (87       | )          | $         | (1,223     | )          | $          | (1,178 | ) | $ | (45 | ) |
|             |            |            |           |            |           |            |            |            |           |            |           |            |            |            |  |  |  |  |  |  |  |  |  |  |  |

 

In the medical segment, the lower grossprofit and higher spending for R&D resulted in an operating loss for Q205.  In the industrial segment, higheroverhead costs related to production of endoscopes caused the operating loss inQ2 05.  In the corporate segment, thelower cost for stock-based compensation for non-qualified options tonon-employees was the primary driver for the lower loss.  These reasons were also the primary driversfor the lower operating losses for 6M 05, compared to 6M 04.

 

Liquidity and CapitalResources

At September 30, 2004, our principal source ofliquidity was working capital of approximately $3.0 million, including$1.7 million in cash and cash equivalents. At September 30, 2004, we had acceptances payable to a bank totalingapproximately $56,000.  We have pledged$125,000 to secure the acceptances payable.

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

Our cash and cash equivalents decreased byapproximately $998,000 in the six months ended September 30, 2004, dueprimarily to cash used for operations of approximately $883,000 and cash usedfor investing activities of approximately $413,000.  These uses were partially offset by financingactivities, including the exercise of stock options by employees andnon-employees, resulting in approximately $298,000 of cash generated.  We expect that our current balance of cashand cash equivalents will not be sufficient to fund our operations for the nexttwelve months.

 

We have incurred losses since our inception,and losses are expected to continue at least during FY 05.  We have funded the losses principally withthe proceeds from public and private equity financings.  The private equity financings have includedsales of new common stock to two employees who are also directors, to other directorsand to private individuals.  There is nocommitment from these investors that they will continue to purchase new commonstock, and we cannot be sure they will be a source of liquidity to us in thefuture.

 

Management has decided that new financing isrequired to fund operations. However, there can be no assurance that additionalfunding will be available, or available on reasonable terms.  If we are not able to secure new financing,our ability to satisfy our operating obligations could be in jeopardy.

 

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We expect total spending for property andequipment to be approximately $700,000 for FY 05.

 

We conduct ouroperations in certain facilities leased from non-related parties.  These leases expire on various dates throughOctober 31, 2006.  In addition, we haveoperating leases for certain office equipment leased from non-relatedparties.  These leases expire on variousdates through May 2006.  The followingchart summarizes our contractual obligations as of March 31, 2004.

 
| **Contractual Obligation** | ** ** | ** ** | **Total** | ** ** | **Due within 1 year** | ** ** | **Due in 1-3 years** | ** ** |
|----------------------------|------------|------------|-----------|------------|-----------------------|------------|----------------------|------------|
| Operating leases           |       | $          | 701,347   |       | $                     | 331,723    |                 | $          | 369,624 |   |
|                            |            |            |           |            |                       |            |                      |            |  |  |  |

 

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

 

 

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

 

In the normal course of business, we aresubject to the risks associated with fluctuations in interest rates and changesin foreign currency exchange rates.

 

#### *Interest and Market Risk*

 

We currently invest ourexcess cash in a money market account at our bank.  We have not used derivative financialinstruments in our investment portfolio. We attempt to limit our exposure to interest rate and credit risk byplacing our investments with high-quality financial institutions and haveestablished investment guidelines relative to diversification and maturitiesdesigned to maintain safety and liquidity.

 

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

 

#### *Foreign CurrencyExchange*

 

We face exposure, due to purchases of rawmaterials from Japanese suppliers, to adverse movements in the value of the JapaneseYen.  This exposure may change over time,and could have a materially adverse effect on our financial results.  We may attempt to limit this exposure bypurchasing forward contracts, as required. Most of our Japanese Yen liabilities are settled within 90 days ofreceipt of materials.  At September 30,2004, our liabilities relating to Japanese Yen were approximately $160,000.

 

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

 

*a)**           **Evaluationof Disclosure Controls and Procedures.*

 

Based on an evaluation of our disclosurecontrols and procedures (as defined in Rules 13a-15(a) and 15d-15(e) under theSecurities Exchange Act of 1934), the chief executive officer and chieffinancial officer have concluded that our disclosure controls and procedures asof the end of the three months ended September 30, 2004, are designed to ensurethat information required to be disclosed by us in the reports that we file orsubmit under the Exchange Act is recorded, processed, summarized and reportedwithin the time periods specified in the SEC’s rules and forms and areoperating in an effective manner.

 

*b)**           **Changesin Internal Controls Over Financial Reporting.*

 

Therewere no significant changes in our internal controls over financial reportingor in other factors that could significantly affect these controls during thefiscal quarter ended September 30, 2004.

 

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**PART II - OTHER INFORMATION**

 

**Item 4.  Submission of Matters to a Vote of Stockholders**

 

We held the 2004 AnnualGeneral Meeting of Shareholders (the “Annual Meeting”) on July 21, 2004.  At the Annual Meeting, the following actionswere taken:

 

1.               Thestockholders re-elected William F. Doyle, Lewis C. Pell and John J. Wallace asClass I directors to serve for a three-year term.  Holders of 16,424,283 shares of Common Stockvoted for and holders of 8,600 shares of Common Stock voted against Mr.Doyle.  Holders of 16,402,836 shares ofCommon Stock voted for and holders of 30,047 shares of Common Stock votedagainst Mr. Pell.  Holders of 16,426,883shares of Common Stock voted for and holders of 6,000 shares of Common Stockvoted against Mr. Wallace.  In additionto Mr. Doyle, Mr. Pell and Mr. Wallace, Mr. Katsumi Oneda, Mr. Ron Hadani andMr. Kenneth W. Anstey continue to serve on the Board of Directors.

2.               Thestockholders ratified the selection of BDO Seidman LLP as our independentpublic accountants for the fiscal year ending March 31, 2005.  Holders of 16,432,883 shares of Common Stockvoted for, and there were no votes against or abstentions from voting on theratification of BDO Seidman LLP as our independent public accountants.

 

**Item 5.  Other Information**

 

 

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

 

(a)                                  Exhibits

 

31.1                                       Certification ofChief Executive Officer pursuant to Rule 13a-15(a)/15d-15(e), promulgated underthe Securities Exchange Act of 1934, as amended.

 

31.2                                       Certificationof Chief Financial Officer pursuant to Rule 13a-15(a)/15d-15(e), promulgatedunder the Securities Exchange Act of 1934, as amended.

 

32                                                Certificationof Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C.§1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

(b)                                 Reports on Form8-K

On November 5, 2004, we furnished a current report on Form 8-Kattaching our press release announcing our financial results for the secondquarter ended September 30, 2004.

 

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##### **SIGNATURES**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the Registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 

VISION-SCIENCES,INC.

 
| Date:  November 12, 2004      |   | /s/  Ron Hadani                                                                                                                       |   |
|-------------------------------|--------|---------------------------------------------------------------------------------------------------------------------------------------|--------|
|                          |   | Ron  Hadani                                                                                                                           |
|                          |   | President,  CEO (Duly Authorized Officer)                                                                                             |
|                          |   |                                                                                                                                  |
|  Date: November 12, 2004 |   | /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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