**UNITED STATES SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

** **

**FORM 10-Q**

**(mark one)**

**x****       ****Quarterly report pursuant toSection 13 or 15(d) of the Securities Exchange Act of 1934**

**For thequarterly period ended June 30, 2006**

 

**o****          ****Transition Report Pursuant toSection 13 or 15(d) of the Securities Exchange Act of 1934**

**Commission file number000-50856**

** **

**NEUROMETRIX, INC.**

(Exact name of registrantas specified in its charter)
| **Delaware**                                      | ** ** | **04-3308180**                        |
|---------------------------------------------------|------------|---------------------------------------|
| (State or other  jurisdiction of incorporation or |       | (I.R.S. Employer  Identification No.) |
| organization)                                     |       |                                  |
|                                              |       |                                  |
| **62  Fourth Avenue, Waltham, Massachusetts**     | ** ** | **02451**                             |
| (Address of  principal executive offices)         |       | (Zip Code)                            |

 

**(781)890-9989** (Registrant’stelephone number, including area code)

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding twelve (12) months (or for such shorter period that the registrantwas required to file such reports), and (2) has been subject to suchfiling requirements for the past ninety (90) days.

Yes x    No o

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer” and “largeaccelerated filer” in Rule 12b-2 of the Exchange Act (check one):

Large accelerated filer o  Accelerated filer x  Non-accelerated filer o

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).

Yes o     No x

APPLICABLE ONLY TOCORPORATE ISSUERS

Indicate the number ofshares outstanding of each of the issuer’s classes of common stock as of thelatest practicable date:

12,523,620 shares of common stock, par value $0.0001 per share, wereoutstanding as of August 4, 2006.

 

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**NEUROMETRIX,INC.**

**FORM 10-Q**

**INDEX**

| **PART I — FINANCIAL INFORMATION** | ** ** |
|----------------------------------------------|------------|
|                                         |       |   |   |
| Item 1.                                      |       | Condensed Financial Statements |   |
|                                         |       |   |   |
|                                         |       | Balance Sheets (unaudited) as of June 30, 2006 and  December 31, 2005 |   |
|                                         |       |   |   |
|                                         |       | Statements  of Operations (unaudited) for the three and six months ended June 30, 2006  and 2005 |   |
|                                         |       |   |   |
|                                         |       | Statements of Cash Flows (unaudited) for the six  months ended June 30, 2006 and 2005 |   |
|                                         |       |   |   |
|                                         |       | Notes  to Financial Statements (unaudited) |   |
|                                         |       |   |   |
| Item 2.                                      |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations |   |
|                                         |       |   |   |
| Item 3.                                      |       | Quantitative and Qualitative Disclosures About Market  Risk |   |
|                                         |       |   |   |
| Item 4.                                      |       | Controls and Procedures |   |
|                                         |       |   |   |
| **PART II  — OTHER INFORMATION**   |       |
|                                         |       |   |   |
| Item  1.                                     |       | Legal  Proceedings |   |
|                                         |       |   |   |
| Item  1A.                                    |       | Risk Factors |   |
|                                         |       |   |   |
| Item 2.                                      |       | Unregistered Sales of Equity Securities and Use of  Proceeds |   |
|                                         |       |   |   |
| Item 3.                                      |       | Defaults Upon Senior Securities |   |
|                                         |       |   |   |
| Item 4.                                      |       | Submission of Matters to a Vote of Security Holders |   |
|                                         |       |   |   |
| Item  5.                                     |       | Other  Information |   |
|                                         |       |   |   |
| Item 6.                                      |       | Exhibits |   |
|                                         |       |   |   |
| Signatures                                   |       |
|                                              |            |  |  |  |

 

2

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**PartIFinancial Information**

**Item 1. CondensedFinancial Statements**

**NeuroMetrix, Inc.**

**Balance Sheets**

**(Unaudited)**
| ** **                                                                                                                                                                          | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| **Assets**                                                                                                                                                                          | ** ** | ** **              | ** ** | ** **                  | ** ** |
| Current assets:                                                                                                                                                                     |       |                    |       |                        |       |
| Cash and cash  equivalents                                                                                                                                                          |       | $                       | 5,161,894  |                        | $          | 8,170,037 |   |
| Short-term  held-to-maturity investments                                                                                                                                            |       | 29,502,186              |       | 24,081,946                  |       |
| Accounts  receivable, net of allowance for doubtful accounts of $525,000 and $400,000  at June 30, 2006 and December 31, 2005, respectively                                    |       | 6,320,363               |       | 4,543,339                   |       |
| Inventories, net                                                                                                                                                                    |       | 2,944,863               |       | 2,683,409                   |       |
| Prepaid expenses  and other current assets                                                                                                                                          |       | 762,922                 |       | 614,169                     |       |
| Current portion  of deferred costs                                                                                                                                                  |       | 280,724                 |       | 223,009                     |       |
| Total current  assets                                                                                                                                                               |       | 44,972,952              |       | 40,315,909                  |       |
|                                                                                                                                                                                |       |                    |       |                        |       |
| Restricted cash                                                                                                                                                                     |       | 1,458,598               |       | 1,458,598                   |       |
| Fixed assets,  net                                                                                                                                                                  |       | 973,746                 |       | 875,551                     |       |
| Deferred costs                                                                                                                                                                      |       | 302,430                 |       | 247,013                     |       |
| Total assets                                                                                                                                                                        |       | $                       | 47,707,726 |                        | $          | 42,897,071 |   |
|                                                                                                                                                                                |       |                    |       |                        |       |
| **Liabilities and Stockholders’  Equity**                                                                                                                                      | ** ** | ** **              | ** ** | ** **                  | ** ** |
| Current liabilities:                                                                                                                                                                |       |                    |       |                        |       |
| Accounts payable                                                                                                                                                                    |       | $                       | 1,599,182  |                        | $          | 1,698,583 |   |
| Accrued  compensation                                                                                                                                                               |       | 2,290,545               |       | 1,959,621                   |       |
| Other accrued  expenses                                                                                                                                                             |       | 1,146,041               |       | 1,213,928                   |       |
| Current portion  of deferred revenue                                                                                                                                                |       | 1,012,268               |       | 760,613                     |       |
| Total current  liabilities                                                                                                                                                          |       | 6,048,036               |       | 5,632,745                   |       |
|                                                                                                                                                                                |       |                    |       |                        |       |
| Deferred revenue                                                                                                                                                                    |       | 1,118,714               |       | 885,354                     |       |
| Other long-term  liabilities                                                                                                                                                        |       | 101,818                 |       | 130,909                     |       |
| Total  liabilities                                                                                                                                                                  |       | 7,268,568               |       | 6,649,008                   |       |
|                                                                                                                                                                                |       |                    |       |                        |       |
| Commitments and  contingencies                                                                                                                                                      |       |                    |       |                        |       |
|                                                                                                                                                                                |       |                    |       |                        |       |
| Stockholders’ equity:                                                                                                                                                          |       |                    |       |                        |       |
| Preferred stock,  $0.001 par value, 5,000,000 shares authorized, none outstanding                                                                                                   |       | —                  |       | —                      |       |
| Common stock,  $0.0001 par value; 50,000,000 shares authorized; 12,512,729 and 12,375,276  shares issued and outstanding at June 30, 2006 and December 31, 2005,  respectively |       | 1,251                   |       | 1,238                       |       |
| Additional  paid-in capital                                                                                                                                                         |       | 95,579,515              |       | 93,212,368                  |       |
| Deferred  compensation                                                                                                                                                              |       | (279,726                | )          | (425,623                    | )          |
| Accumulated  deficit                                                                                                                                                                |       | (54,861,882             | )          | (56,539,920                 | )          |
| Total  stockholders’ equity                                                                                                                                                    |       | 40,439,158              |       | 36,248,063                  |       |
| Total liabilities and  stockholders’ equity                                                                                                                                    |       | $                       | 47,707,726 |                        | $          | 42,897,071 |   |

 

The accompanyingnotes are an integral part of these financial statements.

3

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**NeuroMetrix, Inc.**

**Statements of Operations**

**(Unaudited)**
| ** **                                                                  | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-----------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                                  | ** ** | **June 30, 2006**      | ** ** | **June 30, 2005**    | ** ** | **June 30, 2006** | ** ** | **June 30, 2005** | ** ** |
| Revenues:                                                                   |       |                             |       |                           |       |   |   |   |   |
| Diagnostic  device                                                          |       | $                                | 1,933,594  |                           | $          | 960,513 |   | $ | 3,475,031 |   | $ | 1,772,913 |   |
| Biosensor                                                                   |       | 12,036,456                       |       | 7,106,993                      |       | 22,318,294 |   | 13,084,357 |   |
| Total revenues                                                              |       | 13,970,050                       |       | 8,067,506                      |       | 25,793,325 |   | 14,857,270 |   |
|                                                                        |       |                             |       |                           |       |   |   |   |   |
| Cost of revenues                                                            |       | 3,377,466                        |       | 2,090,064                      |       | 6,257,379 |   | 3,907,789 |   |
| Gross margin                                                                |       | 10,592,584                       |       | 5,977,442                      |       | 19,535,946 |   | 10,949,481 |   |
|                                                                        |       |                             |       |                           |       |   |   |   |   |
| Operating expenses:                                                         |       |                             |       |                           |       |   |   |   |   |
| Research and  development(1)                                                |       | 1,268,545                        |       | 1,029,070                      |       | 2,527,153 |   | 1,933,274 |   |
| Sales and  marketing(1)                                                     |       | 5,408,315                        |       | 3,494,499                      |       | 10,676,568 |   | 6,739,150 |   |
| General and  administrative(1)                                              |       | 2,690,772                        |       | 1,678,480                      |       | 5,246,021 |   | 3,272,520 |   |
| Total operating  expenses                                                   |       | 9,367,632                        |       | 6,202,049                      |       | 18,449,742 |   | 11,944,944 |   |
|                                                                        |       |                             |       |                           |       |   |   |   |   |
| Income (loss)  from operations                                              |       | 1,224,952                        |       | (224,607                       | )          | 1,086,204 |   | (995,463 | ) |
|                                                                        |       |                             |       |                           |       |   |   |   |   |
| Interest income                                                             |       | 372,348                          |       | 184,667                        |       | 665,934 |   | 361,047 |   |
| Interest expense                                                            |       | —                           |       | (204                           | )          | — |   | (2,042 | ) |
|                                                                        |       |                             |       |                           |       |   |   |   |   |
| Income (loss)  before provision for income taxes                            |       | 1,597,300                        |       | (40,144                        | )          | 1,752,138 |   | (636,458 | ) |
| Provision for  income taxes                                                 |       | 66,600                           |       | —                         |       | 74,100 |   | — |   |
|                                                                        |       |                             |       |                           |       |   |   |   |   |
| Net income  (loss)                                                          |       | $                                | 1,530,700  |                           | $          | (40,144 | ) | $ | 1,678,038 |   | $ | (636,458 | ) |
|                                                                        |       |                             |       |                           |       |   |   |   |   |
| Net income (loss) per  common share                                         |       |                             |       |                           |       |   |   |   |   |
| Basic                                                                       |       | $                                | 0.12       |                           | $          | (0.00 | ) | $ | 0.13 |   | $ | (0.05 | ) |
| Diluted                                                                     |       | $                                | 0.12       |                           | $          | (0.00 | ) | $ | 0.13 |   | $ | (0.05 | ) |
|                                                                        |       |                             |       |                           |       |   |   |   |   |
| Weighted average shares  used to compute net income (loss) per common share |       |                             |       |                           |       |   |   |   |   |
| Basic                                                                       |       | 12,485,205                       |       | 12,085,448                     |       | 12,450,037 |   | 12,064,393 |   |
| Diluted                                                                     |       | 13,137,867                       |       | 12,085,448                     |       | 13,136,868 |   | 12,064,393 |   |
|                                                                        |       |                             |       |                           |       |   |   |   |   |

----

(1)             Non-cashstock-based compensation expense included in these amounts is as follows:
| Research and  development   |   | $       | 76,967 |   | $      | 19,162  |   | $      | 295,718 |   | $ | 39,042 |   |
|-----------------------------|--------|---------|--------|--------|--------|---------|--------|--------|---------|--------|---|--------|--------|
| Sales and  marketing        |   | 200,147 |   | 33,501 |   | 391,055 |   | 69,770 |    |
| General and  administrative |   | 349,654 |   | 19,253 |   | 677,208 |   | 39,079 |    |

 

The accompanyingnotes are an integral part of these financial statements.

4

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**NeuroMetrix, Inc.**

**Statements of Cash Flows**

**(Unaudited)**
| ** **                                                                                           | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                                           | ** ** | **June 30,  2006**        | ** ** | **June 30,  2005** | ** ** |
| **Cash flows for operating  activities:**                                                            | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Net income  (loss)                                                                                   |       | $                              | 1,678,038  |   | $ | (636,458 | ) |
| Adjustments to  reconcile net income (loss) to net cash provided by (used in) operating  activities: |       |                           |       |   |   |
| Depreciation and  amortization                                                                       |       | 174,314                        |       | 131,052 |   |
| Compensation  expense associated with stock options                                                  |       | 1,363,981                      |       | 147,891 |   |
| Provision for  doubtful accounts                                                                     |       | 343,265                        |       | 50,149 |   |
| Amortization of  premium on investments                                                              |       | 102,115                        |       | 249,417 |   |
| Provision for  income taxes                                                                          |       | 74,100                         |       | — |   |
| Changes in operating  assets and liabilities:                                                        |       |                           |       |   |   |
| Accounts receivable                                                                                  |       | (2,120,289                     | )          | (647,549 | ) |
| Inventories                                                                                          |       | (261,454                       | )          | (733,866 | ) |
| Prepaid expenses and other current assets                                                            |       | (119,053                       | )          | 14,229 |   |
| Accounts payable                                                                                     |       | (99,401                        | )          | 594,692 |   |
| Accrued compensation and other accrued expenses                                                      |       | 263,037                        |       | 490,440 |   |
| Other long-term liabilities                                                                          |       | (29,091                        | )          | (29,091 | ) |
| Deferred revenue and deferred costs                                                                  |       | 371,883                        |       | 244,890 |   |
| Net cash  provided by (used in) operating activities                                                 |       | 1,741,445                      |       | (124,204 | ) |
|                                                                                                 |       |                           |       |   |   |
| **Cash flows for investing  activities:**                                                            | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Purchases of  investments                                                                            |       | (23,752,079                    | )          | (7,433,535 | ) |
| Maturities of  investments                                                                           |       | 18,229,724                     |       | 8,434,179 |   |
| Purchases of  fixed assets                                                                           |       | (272,509                       | )          | (245,209 | ) |
| Net cash  provided by (used in) investing activities                                                 |       | (5,794,864                     | )          | 755,435 |   |
|                                                                                                 |       |                           |       |   |   |
| **Cash flows from financing  activities:**                                                           | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Proceeds from  exercise of stock options                                                             |       | 828,363                        |       | 73,285 |   |
| Proceeds from  issuance of common stock under employee stock purchase plan                           |       | 216,913                        |       | 127,263 |   |
| Net cash  provided by financing activities                                                           |       | 1,045,276                      |       | 200,548 |   |
|                                                                                                 |       |                           |       |   |   |
| Net increase  (decrease) in cash and cash equivalents                                                |       | (3,008,143                     | )          | 831,779 |   |
| Cash and cash  equivalents, beginning of period                                                      |       | 8,170,037                      |       | 1,936,241 |   |
| Cash and cash  equivalents, end of period                                                            |       | $                              | 5,161,894  |   | $ | 2,768,020 |   |

 

The accompanyingnotes are an integral part of these financial statements.

5

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**NeuroMetrix, Inc.**

**Notes to Financial Statements**

**1.            Nature of the Business and Basis of Presentation**

NeuroMetrix, Inc.(the “Company”), a Delaware corporation, was formed in June 1996. TheCompany designs, develops and sells proprietary medical devices used todiagnose neuropathies. Neuropathies are diseases of the peripheral nerves andparts of the spine that frequently are caused by or associated with diabetes,low back pain and carpal tunnel syndrome, as well as other clinical disorders.The Company operates in one business segment.

The accompanyingunaudited balance sheet as of June 30, 2006 and unaudited statements ofoperations for the three and six month periods ended June 30, 2006 and 2005 andthe unaudited statements of cash flows for the six month periods ended June 30,2006 and 2005 have been prepared in accordance with accounting principlesgenerally accepted in the United States of America for interim financialinformation and with the instructions to Form 10-Q and Article 10 ofRegulation S-X. Accordingly, they do not include all of the information andfootnotes required by accounting principles generally accepted in the UnitedStates of America for complete financial statements. In the opinion ofmanagement, all adjustments (consisting only of normal recurring accruals)considered necessary for a fair statement of the results of operations havebeen included. Operating results for the six month period ended June 30, 2006are not necessarily indicative of the results that may be expected for the yearending December 31, 2006 or any other period. These financial statementsand notes should be read in conjunction with the financial statements for theyear ended December 31, 2005 included in the Company’s Annual Report onForm 10-K (File No. 000-50856). The accompanying balance sheet as ofDecember 31, 2005 has been derived from audited financial statementsprepared at that date, but does not include all disclosures required byaccounting principles generally accepted in the United States of America.

**Use ofEstimates**

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities andthe disclosure of contingent liabilities at the date of the financialstatements and the reported amounts of revenues and expenses during thereporting period. Actual results could differ from those estimates.

**RecentAccounting Pronouncement**

In July 2006, theFinancial Accounting Standards Board (“FASB”) issued FASB Interpretation No.48, *Accounting for Uncertainty in IncomeTaxes—an interpretation of FASB Statement No. 109*(“FIN No. 48”),which clarifies the accounting and disclosure for uncertainty in tax positions,as defined. FIN No. 48 seeks to reduce the diversity in practice associatedwith certain aspects of the recognition and measurement related to accountingfor income taxes. This interpretation is effective for fiscal years beginningafter December 15, 2006. The Company has not yet determined the impact thisinterpretation will have on our results from operations or financial position.

**2.            Accounting for Stock-Based Compensation**

In December 2004,the FASB issued Statement of Financial Accounting Standards (“SFAS”)No. 123(R), “Share Based Payment” (“SFAS No. 123(R)”), which requiresthat the cost resulting from all share-based payment transactions be recognizedin the financial statements. SFAS No. 123(R) revises SFASNo. 123 “Accounting for Stock-Based Compensation” (“SFAS No. 123”)and supersedes Accounting Principles Board Opinion No. 25, “Accounting forStock Issued to Employees” (“APB No. 25”) and SFAS No. 148, “Accountingfor Stock Based Compensation—Transition and Disclosure—an amendment ofFinancial Accounting Standards Board Statement No. 123”. As a result,beginning January 1, 2006, the Company adopted SFASNo. 123(R) using the modified prospective method and has begunreflecting the stock-based compensation expense determined under fair valuebased methods in statement of operations rather than as pro forma disclosure inthe notes to the financial statements. Under this transition method, thecompensation cost recognized beginning January 1, 2006 includes compensationcost for (i) all share-based payments granted prior to, but not yet vestedas of January 1, 2006, based on the grant-date fair value estimated inaccordance with the provisions of SFAS No. 123, and (ii) all sharebased payments granted subsequent to January 1, 2006 based on thegrant-date fair value estimated in accordance with the provisions of SFASNo. 123(R). Compensation cost is generally recognized ratably over therequisite service period. Prior period amounts have not been restated. The Companyuses the Black-Scholes option pricing model for determining the fair value ofits stock options and amortizes its stock-based compensation expense using thestraight-line method.

During 1996, the Companyadopted the 1996 Stock Option/Restricted Stock Plan (the “1996 Stock Plan”).The 1996 Stock Plan provides for the granting of incentive and non-qualifiedstock options and stock bonus awards to officers, directors and employees ofthe Company. The maximum number of shares that may be issued pursuant to the1996 Stock Plan is 156,250. All of the outstanding options under the 1996 StockPlan are fully vested and terminate 10 years after the grant date, or earlierif the option holder is no longer an executive officer, employee, consultant,advisor or director, as applicable, of the Company. As of June 30, 2006, 6,250shares were subject to outstanding options at a weighted average exercise priceof $0.20 per share, 127,962 shares had been issued under the 1996 Stock Planand no shares were available for future grant. If any options granted under the1996 Stock Plan are forfeited, such shares are not available for future grantand revert back to the founder.

6

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During 1998, the Companyadopted the 1998 Equity Incentive Plan (the “1998 Stock Plan”). The 1998 StockPlan also provides for granting of incentive and nonqualified stock option andstock bonus awards to officers, consultants and employees of the Company. As ofJune 30, 2006, 1,250,000 shares of common stock were authorized for issuanceunder the 1998 Stock Plan, of which 487,709 shares had been issued and 682,812shares were subject to outstanding options at a weighted average exercise priceof $6.66 per share. Outstanding options under the 1998 Stock Plan generallyvest over three or four years and terminate 10 years after the grant date, orearlier if the option holder is no longer an executive officer, employee,consultant, advisor or director, as applicable, of the Company. The 1998 StockPlan was closed to any future grants at the time of the Company’s initialpublic offering and therefore we will not make any additional grants under the1998 Stock Plan.

During 2004, the Companyadopted the 2004 Stock Option and Incentive Plan (the “2004 Stock Plan”). The2004 Stock Plan also provides for granting of incentive and nonqualified stockoption and stock bonus awards to officers, consultants and employees of theCompany. Outstanding options under the 2004 Stock Plan generally vest overthree or four years and terminate 10 years after the grant date, or earlier ifthe option holder is no longer an executive officer, employee, consultant,advisor or director, as applicable, of the Company. As of June 30, 2006,1,946,022 shares of common stock were authorized for issuance under the 2004Stock Plan, of which 71,559 shares had been issued, 613,066 shares were subjectto outstanding options at a weighted average exercise price of $22.78 per shareand 1,261,397 shares were available for future grant. In March 2006, theCompany’s Board of Directors voted to discontinue the provision of the 2004Stock Plan which automatically increased the number of options available forgrant under the 2004 Stock Plan based on the net increase in the total numberof outstanding shares of common stock during the year.

The exercise price ofeach stock option issued under the 1996 and 1998 Stock Plans was specified bythe Board of Directors at the time of grant. However, incentive stock optionsmay not be granted at less than the fair market value of the Company’s commonstock as determined by the Board of Directors at the date of grant or for aterm in excess of 10 years. The exercise price of stock options awarded underthe 2004 Stock Plan may not be less than the fair market value of the commonstock on the date of the option grant. For holders of more than 10% of theCompany’s total combined voting power of all classes of stock, incentive stockoptions may not be granted at less than 110% of the fair market value of theCompany’s common stock at the date of grant and for a term not to exceed fiveyears.

In June 2004, theCompany adopted the 2004 Employee Stock Purchase Plan (“ESPP”). All of ouremployees who have been employed by the Company for at least 60 days and whosecustomary employment is for more than 20 hours per week and for more than fivemonths in any calendar year are eligible to participate. Any employee who owns5% or more of the voting power or value of our stock is not eligible toparticipate and an employee may purchase no more than $25,000 worth of commonstock, valued at the start of the purchase period, in any calendar year. TheESPP authorizes the issuance of up to a total of 375,000 shares of our commonstock to participating employees.

Under the ESPP,participating employees can authorize the Company to withhold up to 10% oftheir earnings during consecutive six-month payment periods for the purchase ofthe shares. At the conclusion of each period, participating employees canpurchase shares at 85% of the lower of their fair market value at the beginningor end of the period. The ESPP is regarded as a compensatory plan according tothe provisions of SFAS No. 123(R). Under this plan, the Company has issued41,911 shares of its common stock through June 30, 2006.

A summary ofactivity under the Company’s 1996, 1998 and 2004 Stock Plans for the six monthsended June 30, 2006 is presented below:
| ** **                             | ** ** | **Number  of Shares** | ** ** | **Exercise  Price Range** | ** **     | **Weighted  Average  Exercise Price** | ** ** |
|----------------------------------------|------------|----------------------------|------------|--------------------------------|----------------|--------------------------------------------|------------|
| Outstanding at  December 31, 2005 |       | 1,120,619                  |       | $                              | 0.200 - 37.230 |                                       | $          | 8.3316 |   |
| Granted at fair value                  |       | 332,500                    |       | 27.280 - 38.600                |           | 30.6666                                    |       |
| Exercised                              |       | (87,860                    | )          | 0.400 - 11.470                 |           | 6.2722                                     |       |
| Forfeited                              |       | (41,152                    | )          | 2.250 - 35.040                 |           | 19.3486                                    |       |
| Outstanding at  March 31, 2006         |       | 1,324,107                  |       | $                              | 0.200 - 38.600 |                                       | $          | 13.7345 |   |
| Granted at fair value                  |       | 20,800                     |       | 26.630 - 38.960                |           | 33.2324                                    |       |
| Exercised                              |       | (40,479                    | )          | 0.400 - 12.600                 |           | 7.5839                                     |       |
| Forfeited                              |       | (2,300                     | )          | 2.250 - 26.630                 |           | 23.4500                                    |       |
| Outstanding at June 30,  2006          |       | 1,302,128                  |       | $                              | 0.200 - 38.960 |                                       | $          | 14.2200 |   |

 

The aggregate intrinsicvalue of options exercised during the second quarter and first six months of2006 was $841,800 and $3.4 million, respectively.

7

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The followingtable summarizes information about stock options outstanding at June 30, 2006:
| **Exercise Price** | ** ** | **Number of   Options   Outstanding** | ** ** | **Weighted Average   Remaining   Contractual   Life (Years)** | ** ** | **Weighted   Average   Exercise Price** | ** ** |
|-------------------------|------------|------------------------------------------------------|------------|----------------------------------------------------------------------------------------|------------|--------------------------------------------------------|------------|
| $0.20 — 1.35       |       | 24,131                                               |       | 3.2                                                                                    |       | $                                                      | 0.6663     |   |
| $2.25 — 2.25       |       | 131,523                                              |       | 6.9                                                                                    |       | $                                                      | 2.2500     |   |
| $4.48 — 8.00       |       | 525,751                                              |       | 8.0                                                                                    |       | $                                                      | 7.9121     |   |
| $8.25 — 9.92       |       | 189,652                                              |       | 8.5                                                                                    |       | $                                                      | 9.5921     |   |
| $10.00 — 14.76     |       | 48,871                                               |       | 8.6                                                                                    |       | $                                                      | 11.2438    |   |
| $17.34 — 29.65     |       | 92,500                                               |       | 9.4                                                                                    |       | $                                                      | 26.8185    |   |
| $30.10 — 38.96     |       | 289,700                                              |       | 9.5                                                                                    |       | $                                                      | 31.7401    |   |
|                    |       | 1,302,128                                            |       | 8.3                                                                                    |       | $                                                      | 14.2200    |   |

 

 Thefollowing table summarizes information about stock options exercisable at June30, 2006:
| **Exercise Price** | ** ** | **Number of   Options   Exercisable** | ** ** | **Weighted   Average   Exercise Price** | ** ** |
|-------------------------|------------|------------------------------------------------------|------------|--------------------------------------------------------|------------|
| $0.20 — 1.35       |       | 24,131                                               |       | $                                                      | 0.6663     |   |
| $2.25 — 2.25       |       | 66,794                                               |       | $                                                      | 2.2500     |   |
| $4.48 — 8.00       |       | 263,552                                              |       | $                                                      | 7.8574     |   |
| $8.25 — 9.92       |       | 29,116                                               |       | $                                                      | 9.3234     |   |
| $10.00 — 14.76     |       | 9,197                                                |       | $                                                      | 10.5328    |   |
| $17.34 — 29.65     |       | 750                                                  |       | $                                                      | 18.0133    |   |
| $30.10 — 38.96     |       | —                                               |       | N/A                                                    |       |
|                    |       | 393,540                                              |       | $                                                      | 6.6551     |   |

 

The weighted averageremaining contractual life for stock options exercisable at June 30, 2006 was7.50 years. The aggregate intrinsic value for stock options outstanding andexercisable at June 30, 2006 was $21,581,400 and $9,368,200, respectively.

Prior toJanuary 1, 2006, the Company accounted for stock-based compensation plansin accordance with the provisions of APB No. 25, as permitted by SFASNo. 123, and accordingly did not recognize compensation expense for the issuanceof options with an exercise price equal to or greater than the market price atthe date of grant. Had the fair value based method as prescribed by SFASNo. 123 been applied by the Company, the effect on net loss and net lossper common share for the second quarter and first six months of 2005 would havebeen as follows:
| ** **                                                                         | ** ** | **Three months  ended** | ** ** | **Six months  ended**  | ** ** |
|------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                                                                         | ** ** | **June 30, 2005**  | ** ** | **June 30, 2005** | ** ** |
| Net loss, as  reported                                                             |       | $                            | (40,144    | )                           | $          | (636,458 | ) |
| Add employee  stock-based compensation expense included in reported net loss       |       | 71,916                       |       | 147,891                     |       |
| Less employee  stock-based compensation expense determined under fair value method |       | (350,630                     | )          | (679,663                    | )          |
| Net loss — pro  forma                                                         |       | (318,858                     | )          | (1,168,230                  | )          |
| Net loss per common  share (basic and diluted)                                     |       |                         |       |                        |       |
| As reported                                                                        |       | $                            | (0.00      | )                           | $          | (0.05 | ) |
| Pro forma                                                                          |       | $                            | (0.03      | )                           | $          | (0.10 | ) |

 

8

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The weighted averagegrant date fair value used in the calculation of stock-based compensationexpense in the accompanying statement of operations for the second quarter andfirst six months of 2006 and the pro forma net income (loss) and earnings(loss) per common share information presented above has been calculated usingthe Black-Scholes option pricing model with the following weighted averageassumptions:
| ** **                                      | ** ** | **Three Months Ended** | ** ** | **Six months ended** | ** ** |
|-------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                      | ** ** | **June 30, 2006**      | ** ** | **June 30, 2005**    | ** ** | **June 30, 2006** | ** ** | **June 30, 2005** | ** ** |
| Risk-free  interest rate                        |       | 4.8%-5.2                         | %          | 3.5%-4.1                       | %          | 4.3%-5.2 | % | 3.5%-4.3 | % |
| Expected  dividend yield                        |       | —                           |       | 3⁄4                         |       | — |   | 3⁄4 |   |
| Expected option  term                           |       | 5 years                          |       | 5 years                        |       | 5 years |   | 5 years |   |
| Volatility                                      |       | 50.0                             | %          | 63.7                           | %          | 50.0 | % | 60.0 | % |
| Weighted average fair  value of options granted |       | $                                | 16.41      |                           | $          | 7.56 |   | $ | 14.96 |   | $ | 5.51 |   |
|                                                 |            |                                  |            |                                |            |  |  |  |  |  |  |  |  |

 

The expected option termof five years was estimated based on an analysis of actual option exercises anda review of comparable medical device companies. The risk-free interest rateassumption was based on the United States Treasury’s constant maturity’s ratefor a five year term (corresponding to the expected option term) on the datethe option was granted. The volatility assumption was based on weeklyhistorical volatility during the time period that corresponds to the expectedoption term and a review of comparable medical device companies. The assumeddividend yield was based on the Company’s expectation of future dividendpayouts. The post-vesting forfeiture rate is based on the historical andprojected average turnover rate using four classifications of employees. Theseassumptions will be evaluated and revised as necessary based on changes inmarket conditions and historical experience.

The Company recordedstock-based compensation expense for the second quarter and first six months of2006 of approximately $626,800 and $1.4 million, respectively. Included in thestock-based compensation expense recorded by the Company in the second quarterand first six months of 2006 is (a) $579,200 and $1.1 million,respectively, in compensation expense relating to stock-options granted toemployees subsequent to the Company’s July 2004 initial public offering (“IPO”)that are accounted for according to the provisions of SFAS No. 123(R);(b) a $52,300 reduction of compensation expense and $49,000 incompensation expense related to stock options granted to non-employees that areaccounted for according to the provisions of Emerging Issues Task Force (“EITF”)Issue No. 96-18 “Accounting for Equity Instruments That Are Issued toOther Than Employees for Acquiring, or in Conjunction with Selling, Goods orServices” (“EITF No. 96-18”); (c) $38,000 and $75,900, respectively,in compensation expense related to the ESPP and accounted for under theprovisions of SFAS No. 123(R) and (d) $61,800 and $125,900,respectively, in compensation expense relating to stock options granted toemployees prior to the Company’s initial public offering that are beingaccounted for using the intrinsic value method according to the provisions ofSFAS No. 123(R).

Stock options granted tonon-employees are recorded at fair value and adjusted to market over thevesting period according to the provisions of EITF No. 96-18. The Companydetermines fair value using the Black-Scholes option pricing model, an expectedterm equal to the remaining vesting period, a risk-free interest ratecorresponding to the expected term, an expected volatility of 50% and adividend yield of zero.

Deferred compensation wasrecorded in connection with stock option grants made prior to the Company’sIPO. The deferred compensation represents the difference between the estimatedmarket value of common stock on the date of grant and the exercise priceassociated with the stock options. The deferred compensation is amortized toexpense over the vesting period of the related stock options. The unamortizedbalance of deferred compensation as of June 30, 2006 is approximately $279,700.

Total unrecognizedstock-based compensation costs related to non-vested stock options wasapproximately $7,087,300 as of June 30, 2006 which related to approximately908,600 shares with a per share weighted fair value of $7.81. This unrecognizedcost is expected to be recognized over a weighted average period ofapproximately 2.3 years.

The Company has no taxwindfall or shortfall as of June 30, 2006 as a result of having a 100%valuation allowance established against deferred tax assets.

9

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**3.            Net Income (Loss) Per Common Share**

The Company accounts forand discloses net income (loss) per common share in accordance with SFASNo. 128, “Earnings Per Share”. Basic net income (loss) per common share iscomputed by dividing net income (loss) by the weighted average number of commonshares outstanding. Diluted net income (loss) per common share is computed bydividing net income (loss) by the weighted average number of common shares anddilutive potential common shares then outstanding. Potential common sharesconsist of shares issuable upon the exercise of stock options (using thetreasury stock method).
| ** **                                          | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-----------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                          | ** ** | **June 30, 2006**      | ** ** | **June 30, 2005**    | ** ** | **June 30, 2006** | ** ** | **June 30, 2005** | ** ** |
| Basic:                                              |       |                             |       |                           |       |   |   |   |   |
| Net income  (loss) available to common stockholders |       | $                                | 1,530,700  |                           | $          | (40,144 | ) | $ | 1,678,038 |   | $ | (636,458 | ) |
|                                                |       |                             |       |                           |       |   |   |   |   |
| Weighted average  shares                            |       | 12,485,205                       |       | 12,085,448                     |       | 12,450,037 |   | 12,064,393 |   |
|                                                |       |                             |       |                           |       |   |   |   |   |
| Basic income  (loss) per common share               |       | $                                | 0.12       |                           | $          | (0.00 | ) | $ | 0.13 |   | $ | (0.05 | ) |
|                                                |       |                             |       |                           |       |   |   |   |   |
| Diluted:                                            |       |                             |       |                           |       |   |   |   |   |
| Net income  (loss) available to common stockholders |       | $                                | 1,530,700  |                           | $          | (40,144 | ) | $ | 1,678,038 |   | $ | (636,458 | ) |
|                                                |       |                             |       |                           |       |   |   |   |   |
| Weighted average  shares                            |       | 12,485,205                       |       | 12,085,448                     |       | 12,450,037 |   | 12,064,393 |   |
| Effect of stock  options                            |       | 652,662                          |       | —                         |       | 686,831 |   | — |   |
| Weighted average  shares, as adjusted               |       | 13,137,867                       |       | 12,085,448                     |       | 13,136,868 |   | 12,064,393 |   |
|                                                |       |                             |       |                           |       |   |   |   |   |
| Diluted income (loss)  per common share             |       | $                                | 0.12       |                           | $          | (0.00 | ) | $ | 0.13 |   | $ | (0.05 | ) |

 

The following potentiallydilutive common shares were excluded from the calculation of diluted net income(loss) per common share because their effect was antidilutive for each of theperiods presented:
| ** **           | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|----------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **           | ** ** | **June 30, 2006**      | ** ** | **June 30, 2005**    | ** ** | **June 30, 2006** | ** ** | **June 30, 2005** | ** ** |
| Options  outstanding |       | 375,200                          |       | 1,278,780                      |       | 396,700 |   | 1,278,780 |   |

 

**4.            Inventories**

Inventories consist ofthe following:
| ** **            | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|-----------------------|------------|-------------------------|------------|-----------------------------|------------|
| Purchased  components |       | $                       | 287,898    |                        | $          | 276,167 |   |
| Finished goods        |       | 2,656,965               |       | 2,407,242                   |       |
|                  |       | $                       | 2,944,863  |                        | $          | 2,683,409 |   |

 

**5.            Other Balance Sheet Items**

Accrued expensesconsist of the following:
| ** **             | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Professional  services |       | $                       | 291,289    |                        | $          | 438,519 |   |
| Other                  |       | 854,752                 |       | 775,409                     |       |
|                   |       | $                       | 1,146,041  |                        | $          | 1,213,928 |   |

 

10

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Product Warranty Costs

The Company accrues estimatedproduct warranty costs at the time of sale which are included in cost of salesin the statements of operations. The amount of the accrued warranty liabilityis based on historical information such as past experience, product failurerates, number of units repaired and estimated cost of material and labor. Theliability for product warranty costs is included in accrued expenses in thebalance sheet.

The following is arollforward of the Company’s accrued warranty liability for the three and sixmonth periods ended June 30, 2006 and 2005:
| ** **                      | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|---------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                      | ** ** | **June 30, 2006**      | ** ** | **June 30, 2005**    | ** ** | **June 30, 2006** | ** ** | **June 30, 2005** | ** ** |
| Balance at  beginning of period |       | $                                | 53,162     |                           | $          | 64,182 |   | $ | 64,122 |   | $ | 59,876 |   |
| Accrual for  warranties         |       | 130,316                          |       | 79,622                         |       | 223,844 |   | 139,316 |   |
| Settlements made                |       | (138,351                         | )          | (72,451                        | )          | (242,839 | ) | (127,839 | ) |
| Balance at end of  period       |       | $                                | 45,127     |                           | $          | 71,353 |   | $ | 45,127 |   | $ | 71,353 |   |

 

There have been noadjustments to the amounts disclosed above for prior periods.

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**Item2.      Management’s Discussion and Analysis of FinancialCondition and Results of Operations**

*Youshould read the following discussion of our financial condition and results ofoperations in conjunction with our condensed financial statements and theaccompanying notes to those financial statements included elsewhere in thisQuarterly Report on Form 10-Q. This discussion contains forward-lookingstatements that involve risks and uncertainties. For a description of factorsthat may cause our actual results to differ materially from those anticipatedin these forward looking statements, please refer to the section of thisQuarterly Report on Form 10-Q titled “Cautionary Note RegardingForward-Looking Statements.”*

**Overview**

NeuroMetrix was foundedin June 1996. We design, develop and sell proprietary medical devices usedto diagnose neuropathies. Our proprietary technology provides physicians withan in-office diagnostic system, the NC-stat System, which enables physicians tomake rapid and accurate diagnoses of neuropathies, including carpal tunnelsyndrome, low back and leg pain and diabetic peripheral neuropathy. The NC-statSystem is comprised of: (1) disposable single use NC-stat biosensors thatare placed on the patient’s body; (2) the NC-stat monitor and relatedcomponents; and (3) the NC-stat docking station, an optional device thatenables the physician’s office to transmit data to our onCall InformationSystem. Each component of the NC-stat System is also sold separately. Thesensitivity of the nervous system to metabolic and mechanical damage,compounded by its limited regenerative ability, creates a market opportunityfor a medical device that can assist in point-of-service diagnoses ofneuropathies in a manner that is cost-effective for the patient and third-partypayer. We believe the ease of use, accuracy and convenience provided by theNC-stat System position it to become a standard of care for the assessment ofneuropathies at the point-of-service.

We derive our revenuesfrom the sale of NC-stat biosensors, monitors and docking stations directly toend users, which are generally physician practice groups. Our NC-statbiosensors are disposable products that are used once and inactivated afteruse. The NC-stat monitor is an electronic instrument that is used with theNC-stat biosensors to perform nerve conduction studies for the purpose ofdiagnosing neuropathies. The NC-stat monitor displays the pertinent results ofnerve conduction studies on an LCD screen immediately at the conclusion of eachstudy. The NC-stat docking station is an optional device that is used totransmit to the onCall Information System data generated by the nerveconduction study performed with the NC-stat monitor. The onCall InformationSystem formulates the data it receives for each test into a detailed reportthat is provided to the customer through facsimile or e-mail.

Reimbursement fromthird-party payers is an important element of success for medical productscompanies. Generally, we believe that the nerve conduction studies performed byour customers with the NC-stat System have been satisfactorily covered bythird-party payers. As our presence in the market expands and the use of theNC-stat System increases, we have experienced and are likely to continueto experience an increased focus from third-party payers and governmentalagencies regarding the reimbursement of nerve conduction studies performedusing the NC-stat System and an increased focus from these organizationsregarding the professional requirements for performing nerve conduction studiesin general. At any point in time, a number of third-party payors may take theposition of not reimbursing our customers for their use of the NC-stat System. Widespreadadoption of the NC-stat System by the medical community is unlikely to occur ifphysicians do not receive satisfactory reimbursement from third-party payersfor procedures performed with the NC-stat System. One of the primary challengeswe face in our business is successfully expanding the market for nerve conductionstudies. A successful market expansion will depend upon, in part, our targetingof primary care and specialty physicians who traditionally have not beentargeted by companies selling equipment used to perform nerve conductionstudies and our ability to alter physicians’ practices relating to thediagnosis of neuropathies. In order to successfully implement this growthstrategy, we have increased our sales force to 50 employees, including 46regional sales managers, as of June 30, 2006. We have also expanded the networkof independent sales agents we use to generate sales leads for our regionalsales managers through the signing of an agreement with Physician Sales &Service (“PSS”). PSS has a direct sales force of nearly 700 representatives. Asa result we now have over 1,000 independent sales agents assisting us in ourefforts to penetrate the market of primary care and specialty care physicians. Wealso will participate in various industry conferences in order to acceleratethe market awareness and adoption of our products. These efforts, as well asthe overall expansion of our business, will provide challenges to ourorganization and may increase the burden on our management and operations. Weplan to monitor our business as it grows and appropriately acquire and allocateresources to address these issues, with a goal of sustaining profitable growth.

Our financial objectiveis to grow our business through the sale of the NC-stat System and additionalproducts that may be commercialized for the diagnosis and treatment ofneuropathies and to achieve sustainable profitability. Our efforts in theremainder of 2006 will continue to focus primarily on sales of the NC-statSystem and continuing our ongoing program of making enhancements andimprovements to the NC-stat System, with the goal of increasing our marketpenetration. During the first six months of 2006, we continued efforts onimprovements to our biosensors, on the development of new biosensors, on thedevelopment of products to diagnose additional neuropathies, and on thedevelopment of a third generation neurodiagnostic system. We are also in theearly stages of designing a drug delivery system for the minimally invasivetreatment of neuropathies by both primary care and specialist physicians. We believethat the accomplishment of these goals will have a positive impact on ourprogress toward the objective of growing the business and achieving sustainableprofitability.

12

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Effective January 1,2006, we adopted Statement of Financial Accounting Standards (“SFAS”)No. 123(R), “Share Based Payment” (“SFAS No. 123(R)”), which requiresthat the cost resulting from all share-based payment transactions be recognizedin the financial statements. SFAS No. 123(R) is a revision of SFASNo. 123, “Accounting for Stock-Based Compensation” (“SFAS No. 123”)and supersedes Accounting Principles Board Opinion No. 25, “Accounting forStock Issued to Employees” (“APB No. 25”) and SFAS No. 148, “Accountingfor Stock Based Compensation—Transition and Disclosure—an amendment ofFinancial Accounting Standards Board Statement No. 123” (“SFASNo. 148”). This statement establishes fair value as the measurementobjective in accounting for share-based payment arrangements and requires allentities to apply a fair value based measurement method in accounting forshare-based payment transactions with employees except for equity instrumentsheld by employee share ownership plans. As a result, beginning January 1,2006, we adopted SFAS No. 123(R) using the modified prospectivemethod and have begun reflecting the stock-based compensation expensedetermined under fair value based methods in the income statement rather thanas pro forma disclosure in the notes to the financial statements. Prior periodresults have not been restated. We use the Black-Scholes option pricing modelfor determining the fair value of its stock options and amortize ourstock-based compensation expense using the straight-line method. During thefirst six months of 2006, we recorded stock-based compensation of approximately$1.4 million. We expect stock-based compensation expense recognized inaccordance with the provisions of SFAS 123(R) in each of the remainingquarters of 2006 to be relatively consistent with the amount recognized in thefirst six months of 2006, but this amount could increase if there areadditional stock options granted. The stock-based compensation expenserecognized in accordance with Emerging Issues Task Force Issue No. 96-18 “Accountingfor Equity Instruments That Are Issued to Other Than Employees for Acquiring,or in Conjunction with Selling, Goods or Services” for option grants tonon-employees may vary significantly based on the performance of the Company’sstock price since these grants are valued at the end of each reporting period.

**Resultsof Operations**

The followingtable presents certain statement of operations information stated as apercentage of total revenues:
| ** **                                       | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|--------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                       | ** ** | **2006**                                            | ** ** | **2005**                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
| Revenues:                                        |       |                                                |       |                                              |       |   |   |   |   |
| Diagnostic  device                               |       | 13.8                                                | %          | 11.9                                              | %          | 13.5 | % | 11.9 | % |
| Biosensor                                        |       | 86.2                                                |       | 88.1                                              |       | 86.5 |   | 88.1 |   |
| Total revenues                                   |       | 100.0                                               |       | 100.0                                             |       | 100.0 |   | 100.0 |   |
|                                             |       |                                                |       |                                              |       |   |   |   |   |
| Cost of revenues                                 |       | 24.2                                                |       | 25.9                                              |       | 24.3 |   | 26.3 |   |
|                                             |       |                                                |       |                                              |       |   |   |   |   |
| Gross margins                                    |       | 75.8                                                |       | 74.1                                              |       | 75.7 |   | 73.7 |   |
|                                             |       |                                                |       |                                              |       |   |   |   |   |
| Operating  expenses:                             |       |                                                |       |                                              |       |   |   |   |   |
| Research and  development                        |       | 9.1                                                 |       | 12.8                                              |       | 9.8 |   | 13.0 |   |
| Sales and  marketing                             |       | 38.7                                                |       | 43.3                                              |       | 41.4 |   | 45.4 |   |
| General and  administrative                      |       | 19.3                                                |       | 20.8                                              |       | 20.3 |   | 22.0 |   |
| Total operating  expenses                        |       | 67.1                                                |       | 76.9                                              |       | 71.5 |   | 80.4 |   |
| Income (loss)  from operations                   |       | 8.8                                                 |       | -2.8                                              |       | 4.2 |   | -6.7 |   |
| Interest income  (expense), net                  |       | 2.7                                                 |       | 2.3                                               |       | 2.6 |   | 2.4 |   |
| Income (loss)  before provision for income taxes |       | 11.4                                                |       | -0.5                                              |       | 6.8 |   | -4.3 |   |
| Provision for  income taxes                      |       | 0.5                                                 |       | —                                            |       | 0.3 |   | — |   |
| Net income (loss)                                |       | 11.0                                                | %          | -0.5                                              | %          | 6.5 | % | -4.3 | % |

 

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**Comparisonof Three Months Ended June 30, 2006 and June 30, 2005**

***Revenues***

The followingtables present a breakdown of our customers, biosensor units used and revenues:
| ** ** | ** ** | **12-Month Period  Ended June 30,** | ** ** | ** ** | ** ** | ** ** | ** ** |
|------------|------------|----------------------------------------------------|------------|------------|------------|------------|------------|
| ** ** | ** ** | **2006**                                           | ** ** | **2005**   | ** ** | **Change** | ** ** | **% Change** | ** ** |
|       |       |                                               |       |       |       |       |       |   |   |
| Customers  |       | 4,068                                              |       | 2,696      |       | 1,372      |       | 50.9 | % |

 
| ** **            | ** ** | **Three Months Ended  June 30,** | ** ** | ** ** | ** ** | ** ** | ** ** |
|-----------------------|------------|-------------------------------------------------|------------|------------|------------|------------|------------|
| ** **            | ** ** | **2006**                                        | ** ** | **2005**   | ** ** | **Change** | ** ** | **% Change** | ** ** |
| Biosensor units  used |       | 287,200                                         |       | 173,100    |       | 114,100    |       | 65.9 | % |

 
| ** **         | ** ** | **($ in thousands)** | ** ** | ** ** | ** ** |
|--------------------|------------|--------------------------------|------------|------------|------------|
| Revenues:          |       |                           |       |       |       |   |   |   |   |
| Diagnostic  device |       | $                              | 1,933.6    |       | $          | 960.5 |   | $ | 973.1 |   | 101.3 |   |
| Biosensor          |       | 12,036.5                       |       | 7,107.0    |       | 4,929.5 |   | 69.4 |   |
| Total revenues     |       | $                              | 13,970.1   |       | $          | 8,067.5 |   | $ | 5,902.5 |   | 73.2 | % |

 

Diagnostic devicerevenues were $1.9 million and $960,500 for the three months ended June 30,2006 and June 30, 2005, respectively, representing a year-over-year increasefor the comparative periods of $973,100, or 101.3%. Of this increase,approximately $777,900 is attributable to a greater number of units sold,primarily as a result of an increase in the number of regional sales managers.In addition, approximately $195,100 of this increase is attributable to anincrease in the list price of our NC-stat monitors and docking stations from$4,000 to $5,000 effective January 1, 2006, which resulted in a higheraverage selling price during the three months ended June 30, 2006 as comparedto the same period in 2005. Diagnostic device revenues accounted for 13.8% and11.9% of our total revenues for the three months ended June 30, 2006 and June30, 2005, respectively.

Biosensor revenues were$12.0 million and $7.1 million for the three months ended June 30, 2006 andJune 30, 2005, respectively, representing a year-over-year increase for thecomparative periods of $4.9 million, or 69.4%. The increase was primarily dueto an increased customer base for our biosensors and increased frequency oftesting by our customers. Biosensor revenues accounted for 86.2% and 88.1% ofour total revenues for the three months ended June 30, 2006 and June 30, 2005,respectively.

Our customers used287,200 biosensor units in the three months ended June 30, 2006, compared to173,100 units for the same period in 2005, an increase for the comparativeperiods of 114,100 units, or 65.9%. This increase in biosensor usage isprimarily the result of the increase in the customer base and increased usage percustomer.

Our total revenues were$14.0 million and $8.1 million for the three months ended June 30, 2006 andJune 30, 2005 respectively, representing a year-over-year increase for thecomparative periods of $5.9 million, or 73.2%. During the 12-month periodending June 30, 2006, a total of 4,068 customers used our NC-stat Systemcompared to 2,696 customers for the same period ending June 30, 2005. Thisrepresents a 50.9% year-over-year increase in the number of customers that usedour NC-stat System.

We expect revenues tocontinue to increase in 2006 as a result of the recent expansion of our salesforce, which grew from 36 employees as of December 31, 2005 to 50employees at the end of the second quarter of 2006, and as a result of theexpansion of our network of independent sales agents, with the addition of PSSand their nearly 700 sales representatives. However, our revenues could benegatively impacted by a variety of factors, including the level of demand fornerve conduction studies, potential for changes in third-party reimbursementfor nerve conduction studies, the overall economy, competitive factors and thefactors described in the section of this Quarterly Report on Form 10-Qtitled “Cautionary Note Regarding Forward-Looking Statements.”

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***Costs and expenses***

The followingtable presents our costs and expenses and net income (loss):
| ** **                                       | ** ** | **Three Months Ended   June 30,** | ** ** | ** ** | ** ** | ** ** | ** ** |
|--------------------------------------------------|------------|-------------------------------------------------------|------------|------------|------------|------------|------------|
| ** **                                       | ** ** | **2006**                                              | ** ** | **2005**   | ** ** | **Change** | ** ** | **% Change** | ** ** |
| ** **                                       | ** ** | **($ in thousands)**                        | ** ** | ** ** | ** ** |
| Cost of revenues:                                |       |                                                  |       |       |       |       |       |   |   |
| Diagnostic  device                               |       | $                                                     | 358.8      |       | $          | 259.8      |       | $ | 99.0 |   | 38.1 | % |
| Biosensor                                        |       | 3,018.7                                               |       | 1,830.3    |       | 1,188.4    |       | 64.9 |   |
| Total costs of  revenues                         |       | 3,377.5                                               |       | 2,090.1    |       | 1,287.4    |       | 61.6 |   |
|                                             |       |                                                  |       |       |       |       |       |   |   |
| Gross Margin:                                    |       |                                                  |       |       |       |       |       |   |   |
| Diagnostic  device                               |       | 1,574.8                                               |       | 700.7      |       | 874.1      |       | 124.7 |   |
| Biosensor                                        |       | 9,017.8                                               |       | 5,276.7    |       | 3,741.0    |       | 70.9 |   |
| Total gross  margin                              |       | 10,592.6                                              |       | 5,977.4    |       | 4,615.1    |       | 77.2 |   |
|                                             |       |                                                  |       |       |       |       |       |   |   |
| Gross Margin %:                                  |       |                                                  |       |       |       |       |       |   |   |
| Diagnostic  device                               |       | 81.4                                                  | %          | 73.0       | %          |       |       |   |   |
| Biosensor                                        |       | 74.9                                                  |       | 74.2       |       |       |       |   |   |
| Total gross  margin %                            |       | 75.8                                                  |       | 74.1       |       |       |       |   |   |
|                                             |       |                                                  |       |       |       |       |       |   |   |
| Operating Expenses:                              |       |                                                  |       |       |       |       |       |   |   |
| Research and  development(1)                     |       | 1,268.5                                               |       | 1,029.1    |       | 239.5      |       | 23.3 |   |
| Sales and  marketing(1)                          |       | 5,408.3                                               |       | 3,494.5    |       | 1,913.8    |       | 54.8 |   |
| General and  administrative(1)                   |       | 2,690.8                                               |       | 1,678.5    |       | 1,012.3    |       | 60.3 |   |
| Total operating  expenses                        |       | 9,367.6                                               |       | 6,202.0    |       | 3,165.6    |       | 51.0 |   |
|                                             |       |                                                  |       |       |       |       |       |   |   |
| Income (loss)  from operations                   |       | 1,225.0                                               |       | (224.6     | )          | 1,449.6    |       | -645.4 |   |
|                                             |       |                                                  |       |       |       |       |       |   |   |
| Interest income                                  |       | 372.3                                                 |       | 184.7      |       | 187.7      |       | 101.6 |   |
| Interest expense                                 |       | —                                                |       | (0.2       | )          | 0.2        |       | -100.0 |   |
|                                             |       |                                                  |       |       |       |       |       |   |   |
| Income (loss)  before provision for income taxes |       | 1,597.3                                               |       | (40.1      | )          | 1,637.4    |       | -4,078.9 |   |
| Provision for  income taxes                      |       | 66.6                                                  |       | —     |       | 66.6       |       | N/A |   |
| Net income (loss)                                |       | $                                                     | 1,530.7    |       | $          | (40.1      | )          | $ | 1,570.8 |   | -3,913.0 |   |

----

(1)             Includes non-cashstock-based compensation expense of:
| Research and  development  |   | $     | 77.0   |   | $      | 19.2 |   |
|----------------------------|--------|-------|--------|--------|--------|------|--------|
| Sales and  marketing       |   | 200.1 |   | 33.5   |   |
| General and administrative |   | 349.7 |   | 19.3   |   |

 

Gross Margin

Diagnostic device grossmargin increased to $1.6 million, or 81.4% of revenues, for the three monthsended June 30, 2006 from $700,700, or 73.0% of revenues, for the same period in2005. The increase in the gross margin percentage is primarily attributable toan increase in the list price of our NC-stat System from $4,000 to $5,000effective January 1, 2006.

Biosensor gross margin increasedto $9.0 million, or 74.9% of revenues, for the three months ended June 30, 2006from $5.3 million, or 74.2% of revenues, for the same period in 2005. Theincrease in the biosensor gross margin percentage is primarily due tomanufacturing price reductions realized for several of our biosensors duringthe second half of 2005 and the first quarter of 2006 partially offset by achange in the mix of biosensors sold.

Our overall gross margin was$10.6 million, or 75.8% of revenues, for the three months ended June 30, 2006compared to $6.0 million, or 74.1% of revenues, for the same period in 2005.

15

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Research andDevelopment

Our research anddevelopment, or R&D, expenses include expenses associated with ourresearch, product development, clinical, regulatory and quality assurancedepartments.

R&D expensesincreased $239,500, or 23.3%, to $1.3 million for the three months ended June30, 2006 from $1.0 million for the same period in 2005. As a percentage ofrevenues, R&D expenses were 9.1% and 12.8% for the three months ended June30, 2006 and June 30, 2005, respectively. The increase in expenses wasprimarily due to an increase of $198,400 in personnel costs resulting from thehiring of additional employees in our R&D department and increases inemployee compensation. Also contributing to the increase was an increase of$57,800 in stock-based compensation expense due to the adoption of theprovisions of SFAS No. 123(R).

We expect our spending onR&D will increase during the remainder of 2006 due to additional consultingservices and the hiring of several additional employees to support productdevelopment efforts as well as increased clinical study costs. We expectR&D expenses, as a percentage of total revenues, to continue to decreaseslightly due to an expected increase in revenue. This percentage may vary,however, depending primarily on our revenues for the remainder of 2006.

Sales andMarketing

Our sales and marketingexpenses include expenses from the marketing, field sales, sales administrationand reimbursement departments.

Sales and marketingexpenses increased $1.9 million, or 54.8%, to $5.4 million for the three monthsended June 30, 2006 from $3.5 million for the same period in 2005. As apercentage of revenues, sales and marketing expenses were 38.7% and 43.3% forthe three months ended June 30, 2006 and June 30, 2005, respectively. Thechange in expenses was primarily due to an increase of $1.0 million in employeecompensation and benefit costs, including sales commissions paid to ourregional sales managers. This increase is due to the expansion of the salesforce and higher revenues in the second quarter of 2006 compared to the secondquarter of 2005. Also contributing to the change in expenses was an increase of$401,600 in sales commissions paid to our independent regional sales agencies,which were related to our higher revenues in the second quarter of 2006, anincrease in stock-based compensation expense of $166,600 due to the adoption ofthe provisions of SFAS No. 123(R) and an increase of $161,900 in travelexpenses due to the expansion of the sales force. The change in expenses wasalso partially due to an increase of $71,300 in costs for new promotionalmaterials.

We have increased oursales force to 50 employees, including 46 regional sales managers, as of the endof the second quarter of 2006. For the remainder of 2006, we expect sales andmarketing expenses, as a percentage of total revenues, to decrease slightlyfrom the level experienced in 2005. This percentage may vary, however,depending primarily on our revenues for the remainder of 2006.

General andAdministrative

Our general andadministrative expenses include expenses from the executive, finance,administrative, customer service and information technology departments.

General andadministrative expenses increased $1.0 million, or 60.3%, to $2.7 million forthe three months ended June 30, 2006 from $1.7 million for the same period in2005. As a percentage of revenues, general and administrative expenses were19.3% and 20.8% for the three months ended June 30, 2006 and June 30, 2005,respectively. The increase in expenses was primarily due to (a) anincrease in stock-based compensation expense of $330,400 due to the adoption ofthe provisions of SFAS No. 123(R); (b) an increase of $185,000 in baddebt expense; (c) an increase of $165,300 in professional fees for legalservices and accounting and audit services; (d) an increase of $70,100 inrecruiting costs associated with new hires; (e) an increase in creditcard and bank fees of $61,200 related to increased customer transactions; and(f) an increase in printing costs of $40,500 related to the Company’sannual report and proxy statement.

We expect our general andadministrative expenses to increase during the remainder of 2006 as a result ofour expected growth and the expected hiring of additional general andadministrative staff to support this growth. Total general and administrativeexpenses, as a percentage of total revenues, are expected to decrease in 2006,in spite of the anticipated need to hire additional staff. This percentage mayvary, however, depending primarily on our revenues for 2006. We expect to beable to leverage existing resources such that the growth in general andadministrative expenses is anticipated to be less than the growth in our revenues.Furthermore, while we experienced an increase in professional fees in 2005largely due to the effect of the first year of compliance with the provisionsof the Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley 404”), we do not expect thecosts associated with Sarbanes-Oxley 404 to increase in 2006.

Interest Incomeand Expense

Interest income was$372,300 and $184,700 during the three months ended June 30, 2006 and June 30,2005, respectively. Interest income was earned from investments in cashequivalents, short-term investments and long-term investments. Interest incomeincreased during the three months ended June 30, 2006 compared to the sameperiod in 2005 because of increased yields on invested funds in 2006. Interestexpense was immaterial for all periods presented.

16

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**Comparisonof Six Months Ended June 30, 2006 and June 30, 2005**

***Revenues***

The followingtables present a breakdown of our customers, biosensor units used and revenues:
| ** ** | ** ** | **12-Month Period  Ended June 30,** | ** ** | ** ** | ** ** | ** ** | ** ** |
|------------|------------|----------------------------------------------------|------------|------------|------------|------------|------------|
| ** ** | ** ** | **2006**                                           | ** ** | **2005**   | ** ** | **Change** | ** ** | **% Change** | ** ** |
| Customers  |       | 4,068                                              |       | 2,696      |       | 1,372      |       | 50.9 | % |

 
| ** **            | ** ** | **Six Months Ended  June 30,** | ** ** | ** ** | ** ** | ** ** | ** ** |
|-----------------------|------------|-----------------------------------------------|------------|------------|------------|------------|------------|
| ** **            | ** ** | **2006**                                      | ** ** | **2005**   | ** ** | **Change** | ** ** | **% Change** | ** ** |
| Biosensor units  used |       | 542,800                                       |       | 310,700    |       | 232,100    |       | 74.7 | % |
| ** **            | ** ** | ** **                                    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |

 
| ** **         | ** ** | **($ in thousands)** | ** ** | ** ** | ** ** |
|--------------------|------------|--------------------------------|------------|------------|------------|
| Revenues:          |       |                           |       |       |       |   |   |   |   |
| Diagnostic  device |       | $                              | 3,475.0    |       | $          | 1,772.9 |   | $ | 1,702.1 |   | 96.0 |   |
| Biosensor          |       | 22,318.3                       |       | 13,084.4   |       | 9,233.9 |   | 70.6 |   |
| Total revenues     |       | $                              | 25,793.3   |       | $          | 14,857.3 |   | $ | 10,936.1 |   | 73.6 | % |

 

Diagnostic devicerevenues were $3.5 million and $1.8 million for the six months ended June 30,2006 and June 30, 2005, respectively, representing a year-over-year increasefor the comparative periods of $1.7 million or 96.0%. Of this increase,approximately $1.4 million is attributable to a greater number of units sold,primarily as a result of an increase in the number of regional sales managers.In addition, approximately $319,700 of this increase is attributable to anincrease in the list price of our NC-stat monitors and docking stations from$4,000 to $5,000 effective January 1, 2006, which resulted in a higheraverage selling price during the six months ended June 30, 2006 as compared tothe same period in 2005. Diagnostic device revenues accounted for 13.5% and11.9% of our total revenues for the six months ended June 30, 2006 and June 30,2005, respectively.

Biosensor revenues were$22.3 million and $13.1 million for the six months ended June 30, 2006 and June30, 2005, respectively, representing a year-over-year increase for thecomparative periods of $9.2 million, or 70.6%. The increase was primarily due toan increased customer base for our biosensors and increased frequency oftesting by our customers. Biosensor revenues accounted for 86.5% and 88.1% ofour total revenues for the six months ended June 30, 2006 and June 30, 2005,respectively.

Our customers used542,800 biosensor units in the six months ended June 30, 2006, compared to310,700 units for the same period in 2005, an increase for the comparativeperiods of 232,100 units, or 74.7%. This increase in biosensor usage isprimarily the result of the increase in the customer base and increased usageper customer.

Our total revenues were$25.8 million and $14.9 million for the six months ended June 30, 2006 and June30, 2005 respectively, representing a year-over-year increase for thecomparative periods of $10.9 million, or 73.6%. During the 12-month periodending June 30, 2006, a total of 4,068 customers used our NC-stat Systemcompared to 2,696 customers for the same period ending June 30, 2005. Thisrepresents a 50.9% year-over-year increase in the number of customers that usedour NC-stat System.

17

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***Costs and expenses***

The following tablepresents our costs and expenses and net income (loss):
| ** **                                       | ** ** | **Six Months Ended  June 30,** | ** ** | ** ** | ** ** | ** ** | ** ** |
|--------------------------------------------------|------------|-----------------------------------------------|------------|------------|------------|------------|------------|
| ** **                                       | ** ** | **2006**                                      | ** ** | **2005**   | ** ** | **Change** | ** ** | **% Change** | ** ** |
| ** **                                       | ** ** | **($ in thousands)**                | ** ** | ** ** | ** ** |
| Cost of revenues:                                |       |                                          |       |       |       |       |       |   |   |
| Diagnostic device                                |       | $                                             | 661.8      |       | $          | 478.9      |       | $ | 182.9 |   | 38.2 | % |
| Biosensor                                        |       | 5,595.6                                       |       | 3,428.9    |       | 2,166.7    |       | 63.2 |   |
| Total costs of revenues                          |       | 6,257.4                                       |       | 3,907.8    |       | 2,349.6    |       | 60.1 |   |
|                                             |       |                                          |       |       |       |       |       |   |   |
| Gross Margin:                                    |       |                                          |       |       |       |       |       |   |   |
| Diagnostic device                                |       | 2,813.2                                       |       | 1,294.0    |       | 1,519.2    |       | 117.4 |   |
| Biosensor                                        |       | 16,722.7                                      |       | 9,655.5    |       | 7,067.3    |       | 73.2 |   |
| Total gross margin                               |       | 19,535.9                                      |       | 10,949.5   |       | 8,586.5    |       | 78.4 |   |
|                                             |       |                                          |       |       |       |       |       |   |   |
| Gross Margin %:                                  |       |                                          |       |       |       |       |       |   |   |
| Diagnostic device                                |       | 81.0                                          | %          | 73.0       | %          |       |       |   |   |
| Biosensor                                        |       | 74.9                                          |       | 73.8       |       |       |       |   |   |
| Total gross margin %                             |       | 75.7                                          |       | 73.7       |       |       |       |   |   |
|                                             |       |                                          |       |       |       |       |       |   |   |
| Operating Expenses:                              |       |                                          |       |       |       |       |       |   |   |
| Research and development(1)                      |       | 2,527.2                                       |       | 1,933.3    |       | 593.9      |       | 30.7 |   |
| Sales and marketing(1)                           |       | 10,676.6                                      |       | 6,739.1    |       | 3,937.4    |       | 58.4 |   |
| General and  administrative(1)                   |       | 5,246.0                                       |       | 3,272.5    |       | 1,973.5    |       | 60.3 |   |
| Total operating  expenses                        |       | 18,449.7                                      |       | 11,944.9   |       | 6,504.8    |       | 54.5 |   |
|                                             |       |                                          |       |       |       |       |       |   |   |
| Income (loss) from operations                    |       | 1,086.2                                       |       | (995.5     | )          | 2,081.7    |       | -209.1 |   |
|                                             |       |                                          |       |       |       |       |       |   |   |
| Interest income                                  |       | 665.9                                         |       | 361.0      |       | 304.9      |       | 84.4 |   |
| Interest expense                                 |       | —                                        |       | (2.0       | )          | 2.0        |       | -100.0 |   |
|                                             |       |                                          |       |       |       |       |       |   |   |
| Income (loss) before  provision for income taxes |       | 1,752.1                                       |       | (636.5     | )          | 2,388.6    |       | -375.3 |   |
| Provision for income  taxes                      |       | 74.1                                          |       | —     |       | 74.1       |       | N/A |   |
|                                             |       |                                          |       |       |       |       |       |   |   |
| Net income (loss)                                |       | $                                             | 1,678.0    |       | $          | (636.5     | )          | $ | 2,314.5 |   | -363.7 |   |

----

(1)             Includes non-cashstock-based compensation expense of:
| Research and  development   |   | $     | 295.7  |   | $      | 39.0 |   |
|-----------------------------|--------|-------|--------|--------|--------|------|--------|
| Sales and  marketing        |   | 391.1 |   | 69.8   |   |
| General and  administrative |   | 677.2 |   | 39.1   |   |

 

Gross Margin

Diagnostic device grossmargin increased to $2.8 million, or 81.0% of revenues, for the six monthsended June 30, 2006 from $1.3 million, or 73.0% of revenues, for the sameperiod in 2005. The increase in the gross margin percentage is primarilyattributable to an increase in the list price of our NC-stat System from $4,000to $5,000 effective January 1, 2006.

Biosensor gross marginincreased to $16.7 million, or 74.9% of revenues, for the six months ended June30, 2006 from $9.7 million, or 73.8% of revenues, for the same period in 2005.The increase in the biosensor gross margin percentage is primarily due tomanufacturing price reductions realized for several of our biosensors duringthe second half of 2005 and the first quarter of 2006 partially offset by achange in the mix of biosensors sold.

Our overall gross marginwas $19.5 million, or 75.7% of revenues, for the six months ended June 30, 2006compared to $10.9 million, or 73.7% of revenues, for the same period in 2005.

18

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Research and Development

R&D expensesincreased $593,900 or 30.7%, to $2.5 million for the six months ended June 30,2006 from $1.9 million for the same period in 2005. As a percentage ofrevenues, R&D expenses were 9.8% and 13.0% for the six months ended June30, 2006 and June 30, 2005, respectively. The increase in expenses wasprimarily due to an increase of $301,200 in personnel costs resulting from thehiring of additional employees in our R&D department and increases inemployee compensation. This increase is primarily related to efforts expendedon the development of a third generation monitor and docking station and on newbiosensors. Also contributing to the increase was an increase of $256,700 instock-based compensation expense due to the adoption of the provisions of SFASNo. 123(R).

Sales and Marketing

Sales and marketingexpenses increased $3.9 million, or 58.4%, to $10.7 million for the six monthsended June 30, 2006 from $6.7 million for the same period in 2005. As apercentage of revenues, sales and marketing expenses were 41.4% and 45.4% forthe six months ended June 30, 2006 and June 30, 2005, respectively. The changein expenses was primarily due to an increase of $2.4 million in employeecompensation and benefit costs, including sales commissions paid to ourregional sales managers. This increase is due to the expansion of the salesforce and higher revenues in the first six months of 2006 compared to the firstsix months of 2005. Also contributing to the change in expenses was an increaseof $672,000 in sales commissions paid to our independent regional salesagencies, which were related to our higher revenues in the first six months of2006, an increase in stock-based compensation expense of $321,300 due to theadoption of the provisions of SFAS No. 123(R) and an increase of$227,900 in travel expenses due to the expansion of the sales force. The changein expenses was also partially due to an increase of $133,400 in costs for newpromotional materials.

General andAdministrative

General andadministrative expenses increased $2.0 million, or 60.3%, to $5.2 million forthe six months ended June 30, 2006 from $3.3 million for the same period in2005. As a percentage of revenues, general and administrative expenses were20.3% and 22.0% for the six months ended June 30, 2006 and June 30, 2005,respectively. The increase in expenses was primarily due to (a) anincrease in stock-based compensation expense of $638,100 due to the adoption ofthe provisions of SFAS No. 123(R); (b) an increase of $301,200 inprofessional fees for legal services and accounting and audit services;(c) an increase of $290,100 in bad debt expense; (d) an increase inpersonnel costs of $153,100 due to the expansion of staff and increases inemployee compensation; (e) an increase of $120,800 in our insurancecosts; (f) an increase in consulting services of $113,500 primarily toassist the Company with its compliance with Sarbanes-Oxley 404 and the adoptionof new accounting pronouncements; and (g) an increase in credit card and bankfees of $112,300 related to increased customer transactions.

Interest Income andExpense

Interest income was$665,900 and $361,000 during the six months ended June 30, 2006 and June 30,2005, respectively. Interest income was earned from investments in cashequivalents, short-term investments and long-term investments. Interest incomeincreased during the six months ended June 30, 2006 compared to the same periodin 2005 because of increased yields on invested funds in 2006. Interest expensewas immaterial for all periods presented.

**Liquidityand Capital Resources**

Our principalsource of liquidity is our current cash and cash equivalents and short-termheld-to-maturity investments. As of June 30, 2006, the weighted averagematurity of our cash equivalents and short-term held-to-maturity investmentswas 171 days. Our ability to generate cash from operations is dependentupon our ability to generate revenue from sales of our diagnostic devices andconsumable biosensors, as well as our ability to manage our operating costs andnet assets. A decrease in demand for our products or unanticipated increases inour operating costs would likely have an adverse effect on our liquidity and cashgenerated from operations. The following sets forth information relating to ourliquidity:
| ** **                                                                | ** ** | **June 30,  2006**        | ** ** | **December 31,   2005** | ** ** | **Change** | ** ** | **% Change** | ** ** |
|---------------------------------------------------------------------------|------------|--------------------------------|------------|-----------------------------------|------------|------------|------------|-------------------|------------|
| ** **                                                                | ** ** | **($ in thousands)** | ** ** | ** **                        | ** ** |
| Cash and cash  equivalents                                                |       | $                              | 5,162      |                              | $          | 8,170      |       | $                 | (3,008     | ) | -36.8 |   |
| Short-term  held-to-maturity investments                                  |       | 29,502                         |       | 24,082                            |       | 5,420      |       | 22.5              |       |
| Total cash, cash  equivalents and short-term held-to-maturity investments |       | $                              | 34,664     |                              | $          | 32,252     |       | $                 | 2,412      |   | 7.5 | % |

 

During the first sixmonths of 2006, our cash and cash equivalents and short-term held-to-maturityinvestments increased $2.4 million, primarily due to $1.7 million of cashprovided by operations and $1.0 million of proceeds received from the exerciseof stock options and the issuance of common stock under our employee stockpurchase plan, offset in part by cash used for capital expenditures of$272,500.

19

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In managing our workingcapital, two of the financial measurements we monitor are days’ salesoutstanding, or DSO, and inventory turnover rate, which are presented in thetable below for the year ended December 31, 2005 and the three monthsended June 30, 2006 and June 30, 2005:

 

 
| ** **                                | ** ** | **Three Months Ended  June 30,** | ** ** | **Year Ended  December 31,** | ** ** |
|-------------------------------------------|------------|-------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                | ** ** | **2006**                                        | ** ** | **2005**                               | ** ** | **2005** | ** ** |
| Days’ sales  outstanding (days)      |       | 38                                              |       | 40                                     |       | 40 |   |
| Inventory turnover rate  (times per year) |       | 4.5                                             |       | 4.8                                    |       | 4.5 |   |

 

Our payment termsextended to our customers generally require payment within 30 days from invoicedate. At June 30, 2006, our DSO was 38 days, a decrease of 2 days as comparedto December 31, 2005, primarily due to the effect of increased revenues.We continue to focus our efforts on reducing our accounts receivable balancesover 60 days past due. Accounts payable are normally paid within 30 to 40 daysfrom receipt of a vendor’s invoice.

Our inventory turnoverwas 4.5 times for the quarter ended June 30, 2006 and the year of 2005. Weexpect to maintain our inventory levels at approximately two to three months ofinventory during the remainder of 2006.

The following setsforth information relating to the sources and uses of our cash:
| ** **                                           | ** ** | **Six Months Ended  June 30,** | ** ** |
|------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                           | ** ** | **2006**                                      | ** ** | **2005** | ** ** |
| ** **                                           | ** ** | **(in thousands)**                       | ** ** |
| Net cash  provided by (used in) operating activities |       | $                                             | 1,741.4    |   | $ | (124.2 | ) |
| Net cash  provided by (used in) investing activities |       | (5,794.9                                      | )          | 755.4 |   |
| Net cash  provided by financing activities           |       | 1,045.3                                       |       | 200.5 |   |
|                                                 |       |                                          |       |   |   |
|                                                      |            |                                               |            |  |  |  |  |

 

Cash provided byoperating activities was approximately $1.7 million in the first six months of2006, compared with cash used in operating activities of approximately $124,200in the first six months of 2005. A net use of cash of approximately $2.0million for our investment in working capital was offset by $1.7 million in netincome and $2.1 million in non-cash items, mainly compensation expenseassociated with stock options. The primary drivers of our investment in workingcapital were as follows: Our accounts receivable increased $2.1 million,excluding the change in the allowance for doubtful accounts, due to growth inrevenues offset in part by the more rapid collection of amounts due from ourcustomers. Our inventories increased $261,500 primarily due to the growth inour business. The net loss in the first six months of 2005 of $636,500 andincreases of $647,500 in accounts receivable and $733,900 in inventories wereoffset by increases in accounts payable and accrued expenses of $594,700 and$490,400, respectively.

Cash used for investingactivities was $5.8 million in the first six months of 2006, compared with cashprovided by investing activities of $755,400 in the first six months of 2005.In the first six months of 2006 there were net purchases of investments in theamount of approximately $5.5 million, compared with net maturities ofinvestments of approximately $1.0 million in the first six months of 2005. Inthe first six months of 2006 and 2005 cash was used for the purchase of fixedassets, in the amount of $272,500 and $245,200, respectively, primarilyrepresenting computer equipment in 2006 and leasehold improvements and toolingequipment for new products in 2005.

In connection with ourproperty lease entered into at the beginning of January, 2001, we are requiredto maintain, for the benefit of the lessor, an irrevocable standby letter ofcredit stating the lessor as the beneficiary. The original amount of the letterof credit was $1,860,000. During September 2005, in accordance with theterms of the lease agreement, the amount required under the letter of creditwas reduced to $1,430,000. The letter of credit is secured by a certificate ofdeposit in an amount equal to 102% of the letter of credit. The lease expiresin March 2009. The certificate of deposit is renewable in 30-dayincrements. This amount is classified as restricted cash in the balance sheet.

Cash provided byfinancing activities was $1.0 million and $200,500 in the first six months of2006 and 2005, respectively. Cash provided by financing activities in the firstsix months of 2006 and 2005 represents the proceeds from the exercise of stockoptions and the issuance of shares under our employee stock purchase plan.

During the remainder of2006, we will be continuing to expend funds in connection with our efforts toexpand our sales and marketing for the NC-stat System, although more modestlythan the expansion in the last several quarters, and continue our ongoingprogram of making enhancements and improvements to the NC-stat System,including the development of new and/or improved biosensors, products for thediagnosis of additional neuropathies, and the development of a third generationneurodiagnostic system. In connection with the development efforts on a thirdgeneration neurodiagnostic system, we expect to continue to incur additionalcapital expenditures during the remainder of 2006 for production tooling costs.We also plan to expend funds on the design of a drug delivery system, which 

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is in its early stages ofdevelopment, for the minimally invasive delivery of therapeutic agents to treatneuropathies by both primary care and specialist physicians. We also expect toincur capital expenditures for computer hardware and software to support thegrowth in our business and the additional requirements of our customer base. Webelieve that the combination of funds available from cash and cash equivalentsand funds available from our short-term investments will be adequate to financeour ongoing operations for at least 24 months, including the expendituresdescribed above.

To date, inflation hasnot had a material impact on our financial operations.

*Off-BalanceSheet Arrangements*

As of June 30, 2006, wedid not have any off-balance sheet financing arrangements.

**RecentAccounting Pronouncement**

In July 2006, the FASBissued FASB Interpretation No. 48, *Accountingfor Uncertainty in Income Taxes—an interpretation of FASB StatementNo. 109*(“FIN No. 48”), which clarifies the accounting anddisclosure for uncertainty in tax positions, as defined. FIN No. 48 seeks toreduce the diversity in practice associated with certain aspects of therecognition and measurement related to accounting for income taxes. Thisinterpretation is effective for fiscal years beginning after December 15, 2006.The Company has not yet determined the impact this interpretation will have onour results from operations or financial position.

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**CAUTIONARY NOTE REGARDINGFORWARD-LOOKING STATEMENTS**

The statements containedin this quarterly report on Form 10-Q, including under thesection titled “Management’s Discussion and Analysis of FinancialCondition and Results of Operations” and other sections of this quarterlyreport, include forward-looking statements within the meaning of Section 27Aof the Securities Act of 1933, as amended, and Section 21E of theSecurities Exchange Act of 1934, as amended, including, without limitation,statements regarding our or our management’s expectations, hopes, beliefs,intentions or strategies regarding the future. The words “believe,” “may,” “will,”“estimate,” “continue,” “anticipate,” “intend,” “expect,” “plan” and similarexpressions may identify forward-looking statements, but the absence of thesewords does not mean that a statement is not forward-looking. Theforward-looking statements contained in this quarterly report are based on ourcurrent expectations and beliefs concerning future developments and theirpotential effects on us. There can be no assurance that future developmentsaffecting us will be those that we have anticipated. These forward-lookingstatements involve a number of risks, uncertainties (some of which are beyondour control) or other assumptions that may cause actual results or performanceto be materially different from those expressed or implied by theseforward-looking statements. These risks and uncertainties include, but are notlimited to, risks associated with: our dependence on the NC-stat System and itscomponents; our ability to increase our customer base and expand the market forour products; our ability to accurately predict the size of the market for theNC-stat System; our ability to manage our growth; obtaining necessaryregulatory approvals; our reliance on single source third party manufacturersand suppliers to produce our products; reimbursement by third party payors toour customers for procedures performed using the NC-stat System; compliancewith applicable quality control and manufacturing standards; compliance withfederal and state laws protecting the confidentiality of patient healthinformation and prohibiting “kickbacks” and false or fraudulent claims oradverse publicity or costs relating to any investigation into our practicesunder these laws; our ability to retain and recruit key management, scientificand sales personnel; delays in the development of new products or to plannedimprovements to our products; effectiveness of our products compared to othermedical device products; competition; protection of our intellectual propertyand other proprietary rights; conflicts with the intellectual property of thirdparties; product liability lawsuits or claims that may be brought against us;dependence upon computer and communication infrastructure utilized by ourproducts; publication of future clinical studies or other articles orannouncement of positions by physician associations or other organizations thatare unfavorable to our products; our capital and financing needs; oursuccessful integration of any acquired businesses; and the other factors describedin the section of our Annual Report on Form 10-K titled “Item 1A. RiskFactors”, as updated in Part II, Item1A of our Quarterly Report on Form10-Q  for the period ended March 31, 2006and our other filings. Should one or more of these risks or uncertaintiesmaterialize, or should any of our assumptions prove incorrect, actual resultsmay vary in material respects from those projected in these forward-lookingstatements. We undertake no obligation to update or revise any forward-lookingstatements, whether as a result of new information, future events or otherwise,except as may be required under applicable securities laws.

**Item3.    Quantitative and Qualitative Disclosures About Market Risk**

We do not use derivativefinancial instruments in our investment portfolio and have no foreign exchangecontracts. Our financial instruments consist of cash, cash equivalents,short-term investments, accounts receivable, accounts payable, accrued expensesand long-term obligations. We consider investments that, when purchased, have aremaining maturity of 90 days or less to be cash equivalents. The primaryobjectives of our investment strategy are to preserve principal, maintainproper liquidity to meet operating needs, and maximize yields. To minimize ourexposure to an adverse shift in interest rates, we invest mainly in cashequivalents and short-term investments and long-term investments with amaturity of eighteen months or less and maintain an average maturity of twelvemonths or less. We do not believe that a 10% change in interest rates wouldhave a material impact on the fair value of our investment portfolio or ourinterest income.

**Item4.    Controls and Procedures**

**(a)****             **Evaluation of disclosure controls and procedures.

Our management carriedout an evaluation, with the participation of our Chief Executive Officer andour Chief Financial Officer, of the effectiveness of our disclosure controlsand procedures (as defined in Rules 13a-15(e) or 15d-15(e) underthe Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as ofJune 30, 2006. Based upon that evaluation, our Chief Executive Officer andour Chief Financial Officer concluded that they believe that our disclosurecontrols and procedures are effective to ensure that information required to bedisclosed by us in reports that we file or submit under the Exchange Act, isrecorded, processed, summarized and reported, within the time periods specifiedin the Securities and Exchange Commission’s rules and forms. In designingand evaluating our disclosure controls and procedures, we and our managementrecognize that any controls and procedures, no matter how well designed andoperated, can provide only reasonable assurance of achieving the desiredcontrol objectives, and our management necessarily was required to apply itsjudgment in evaluating and implementing possible controls and procedures. Wecontinue to review and document our disclosure controls and procedures,including our internal controls over financial reporting, and may from time totime make changes aimed at enhancing their effectiveness and to ensure that oursystems evolve with our business.

**(b) **  Changesin internal control over financial reporting.

There was no change inour internal control over financial reporting that occurred during the periodcovered by this Quarterly Report on Form 10-Q that has materiallyaffected, or is reasonably likely to materially affect, our internal controlover financial reporting.

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**Part IIOther Information**

**Item1.   Legal Proceedings**

None.

**Item1A. Risk Factors**

There have been nomaterial changes in the risk factors described in “Item 1A—Risk Factors”of our Annual Report on Form 10-K for the year ended December 31,2005, except as previously noted in our Form 10-Q for the three months endedMarch 31, 2006.

**Item2.   Unregistered Sales of Equity Securities and Use of Proceeds**

(a)          On July 21, 2004, the Securities and Exchange Commission declaredeffective our registration statement on Form S-1 (FileNo. 333-115440), relating to the initial public offering of our commonstock. We expect to continue to use the net proceeds from the initial publicoffering for general corporate purposes, including to expand our selling andmarketing and services organizations, develop new distribution channels, expandour research and development efforts, improve our operational and financialsystems and for other working capital purposes. We may also use a portion ofthe net proceeds to acquire or invest in complementary businesses, products ortechnologies. We have no specific understandings, commitments or agreementswith respect to any such acquisition or investment. Except as set forth below,we have not allocated any portion of the net proceeds for any specific purpose.The aggregate price of the offering amount registered on our behalf was$27.6 million. In connection with the offering, we paid approximately$1.9 million in underwriting discounts and commissions to the underwritersand incurred an estimated $1.7 million in other offering expenses. None ofthe underwriting discounts and commissions or offering expenses were incurredor paid to directors or officers of ours or their associates or to personsowning 10 percent or more of our common stock or to any affiliates ofours. After deducting the underwriting discounts and commissions and offeringexpenses, we received net proceeds from the offering of approximately$24.0 million. From July 21, 2004, the effective date of the registrationstatement, to June 30, 2006 we have used (i) $3.1 million of the netproceeds to repay in full the outstanding balance under our secured line ofcredit with Lighthouse Capital Partners, (ii) an estimated $6.2 million ofthe net proceeds to fund cash spending of our research and developmentactivities, (iii) an estimated $13.1 million of the net proceeds to fundthe expansion of our sales and marketing efforts and (iv) an estimated$789,600 for the purchase of capital equipment. The remainder of the net proceedshave been invested in marketable, investment grade, interest-bearing securitiespending their use. Our use of the proceeds from our initial public offeringdoes not represent a material change from the description provided in ourprospectus.

**Item3.    Defaults Upon Senior Securities**

None.

**Item4.    Submission of Matters to a Vote of Security Holders.**

At the Annual Meeting ofStockholders held on May 24, 2006, our stockholders voted as follows:

(a)           To elect two members to the Board ofDirectors as Class II Directors, to serve until the Company’s 2009 annualmeeting of stockholders and until their successors are duly elected andqualified or until their earlier resignation or removal.
| **Nominee**                  | ** ** | **Vote “For”** | ** ** | **Vote Withheld** | ** ** |
|------------------------------|------------|-------------------------------|------------|------------------------|------------|
|                         |       |                          |       |                   |       |
| Shai N. Gozani,  M.D., Ph.D. |       | 11,214,216                    |       | 202,209                |       |
| Charles R. LaMantia          |       | 11,233,615                    |       | 182,810                |       |

 

There were no brokernon-votes or abstentions with respect to this matter.  The terms in office of Allen J. Hinkle, M.D.,David E. Goodman, M.D., Jonathan T. Lord, M.D. and W. Mark Lortz continuedafter the annual meeting.

(b)           To approve an amendment to theCompany’s Restated and Amended 2004 Stock Option and Incentive Plan, toincrease the number of shares of the Company’s common stock, $0.0001 par valueper share, reserved for issuance thereunder by 1,000,000 shares.

| Vote “For” | ** ** | **Vote “Against”** | ** ** | **Abstentions** | ** ** | **Broker Non-Votes** | ** ** |
|---------------------------|------------|-----------------------------------|------------|-----------------|------------|---------------------------|------------|
| 8,456,165                 |       | 1,160,875                         |       | 12,968          |       | 1,786,417                 |       |

 

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(c)         To ratify the selection of PricewaterhouseCoopers LLP to serve as theCompany’s independent auditors for the year ending December 31, 2006.

| Vote “For” | ** ** | **Vote “Against”** | ** ** | **Abstentions** | ** ** | **Broker Non-Votes** | ** ** |
|---------------------------|------------|-----------------------------------|------------|-----------------|------------|---------------------------|------------|
| 11,406,453                |       | 1,615                             |       | 8,357           |       | —                    |       |

 

**Item5.    Other Information**

None.

**Item6.    Exhibits**

See theExhibit Index on the page immediately preceding the exhibits for alist of exhibits filed as part of this quarterly report, whichExhibit Index is incorporated herein by this reference.

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SIGNATURES

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.
|                      |       | ** ** | **NEUROMETRIX, INC.**                 | ** ** | ** ** |
|----------------------|------------|------------|---------------------------------------|------------|------------|
|                 |       | ** ** | ** **                            | ** ** | ** ** |
| ** **           | ** ** | ** ** | ** **                            | ** ** | ** ** |
| Date: August 9, 2006 | /s/        |       | Shai N. Gozani, M.D., Ph. D.          |       |       |
|                 |       |       | Shai N. Gozani, M.D., Ph. D.          |       |       |
|                 |       |       | Chief Executive Officer and President |       |       |
|                 |       |       |                                  |       |       |
| Date: August 9, 2006 | /s/        |       | W. Bradford Smith                     |       |       |
|                 |       |       | W. Bradford Smith                     |       |       |
|                 |       |       | Chief Financial Officer               |       |       |

 

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Exhibit Index
| 3.1        |   | Form of Second Amended and Restated By-laws of  NeuroMetrix, Inc.(1)                                                                 |
|------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.2        |   | Form of Third Amended and Restated Certificate  of Incorporation of NeuroMetrix, Inc.(1)                                             |
| 4.1        |   | Specimen certificate for shares of common stock(1)                                                                                             |
| †10.1 |   | Manufacturing and Supply Agreement dated August 2,  2006 by and between NeuroMetrix, Inc. and Parlex Polymer Flexible Circuits,  Inc.(2)       |
| *31.1      |   | Certification of Principal Executive Officer  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                   |
| *31.2      |   | Certification of Principal Financial Officer  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                  |
| *32        |   | Certification of Principal Executive Officer and  Principal Financial Officer pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |

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*                    Filedherewith

†                     Portionsof this exhibit have been omitted pursuant to a request for confidentialtreatment.

(1)             Incorporated hereinby reference to NeuroMetrix, Inc.’s Registration Statement on From S-1(Registration No. 333-115440).

(2)             Incorporatedherein by reference to NeuroMetrix, Inc.’s Periodic Report on Form 8-Kfiled on August 2, 2006 (Registration No. 000-50856).

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