**UNITED STATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

 

| **ý**                           |   | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934.**                                                                                                                                                                                                         |
|--------------------------------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                 |   |                                                                                                                                                                                                                                                                                                   |
|                                 |   | **For the quarterly period ended  March 31, 2004.**                                                                                                                                                                                                                                                    |
|                                 |   |                                                                                                                                                                                                                                                                                                   |
| **OR**                               |
|                                 |   |                                                                                                                                                                                                                                                                                                   |
| **o**                                |   | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934.**                                                                                                                                                                                                        |
|                                 |   |                                                                                                                                                                                                                                                                                                   |
|                                 |   | **For the transition period from                         to                       ** |
|                                 |   |                                                                                                                                                                                                                                                                                                   |
| **Commission  File Number: 1-11388** |

 

**PLC SYSTEMSINC.**

(Exact Name of Registrant as Specified in Its Charter)

 

| **Yukon Territory, Canada**                                     |   | **04-3153858**                       |
|-----------------------------------------------------------------|--------|--------------------------------------|
| (State or Other Jurisdiction of  Incorporation or Organization) |   | (I.R.S. Employer Identification No.) |
|                                                            |   |                                 |
| **10 Forge Park, Franklin,  Massachusetts**                     |   | **02038**                            |
| (Address of Principal Executive Offices)                        |   | (Zip Code)                           |

 

Registrant’stelephone number, including area code: **(508) 541-8800**

 

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 the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.  **Yes ****ý   No****o**

 

Indicate by check markwhether the registrant is an accelerated filer (as defined in Rule 12b-2 of theExchange Act)  **Yes ****o  No ****ý**

 

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

 

| **Class**                   |   | **Outstanding  at May 6, 2004** |
|-----------------------------|--------|---------------------------------|
| Common Stock, no  par value |   | 30,054,296                      |

 

 

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**PLC SYSTEMS INC.**

 

**Index**

 
| Part I.  | Financial Information: |                                                                                        |
|----------|------------------------|---------------------------------------------------------------------------------------------|
|     |                   |                                                                                        |   |
|     | Item 1.                | Financial Statements                                                                        |   |
|     |                   |                                                                                        |   |
|     |                   | Condensed  Consolidated Balance Sheets (unaudited)                                          |   |
|     |                   |                                                                                        |   |
|     |                   | Condensed  Consolidated Statements of Operations (unaudited)                                |   |
|     |                   |                                                                                        |   |
|     |                   | Condensed  Consolidated Statements of Cash Flows (unaudited)                                |   |
|     |                   |                                                                                        |   |
|     |                   | Notes  to Condensed Consolidated 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 6.                | Exhibits and  Reports on Form 8-K                                                           |   |

 

2

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**PLC SYSTEMS INC.**

**PartI.  Financial Information**

**Item1.****    FinancialStatements**

 

**PLC SYSTEMS INC.**

CONDENSED CONSOLIDATEDBALANCE SHEETS

(In thousands)

(Unaudited)

 
|                                                                                                                                                            |   | **March 31,  2004** |   | **December  31,  2003** |   |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------|--------|-------------------------|--------|
| ASSETS                                                                                                                                                          |   |                |   |                    |   |
| Current assets:                                                                                                                                                 |   |                |   |                    |   |
| Cash and cash  equivalents                                                                                                                                      |   | $                   | 10,880 |                    | $      | 6,377 |   |
| Accounts  receivable, net of allowance of $135 and $115 in 2004 and 2003, respectively                                                                          |   | 1,386               |   | 1,239                   |   |
| Lease  receivables                                                                                                                                              |   | 260                 |   | 376                     |   |
| Inventories, net                                                                                                                                                |   | 836                 |   | 885                     |   |
| Prepaid expenses  and other current assets                                                                                                                      |   | 686                 |   | 490                     |   |
| Total current  assets                                                                                                                                           |   | 14,048              |   | 9,367                   |   |
|                                                                                                                                                            |   |                |   |                    |   |
| Equipment,  furniture and leasehold improvements, net                                                                                                           |   | 248                 |   | 206                     |   |
| Other assets                                                                                                                                                    |   | 266                 |   | 276                     |   |
| Total assets                                                                                                                                                    |   | $                   | 14,562 |                    | $      | 9,849 |   |
|                                                                                                                                                            |   |                |   |                    |   |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                       |   |                |   |                    |   |
| Current  liabilities:                                                                                                                                           |   |                |   |                    |   |
| Accounts payable                                                                                                                                                |   | $                   | 646    |                    | $      | 297 |   |
| Accrued  compensation                                                                                                                                           |   | 319                 |   | 376                     |   |
| Accrued other                                                                                                                                                   |   | 353                 |   | 358                     |   |
| Deferred revenue                                                                                                                                                |   | 1,132               |   | 555                     |   |
| Secured  borrowings                                                                                                                                             |   | 260                 |   | 376                     |   |
| Total current  liabilities                                                                                                                                      |   | 2,710               |   | 1,962                   |   |
|                                                                                                                                                            |   |                |   |                    |   |
| Deferred revenue                                                                                                                                                |   | 4,563               |   | 331                     |   |
| Total long-term  liabilities                                                                                                                                    |   | 4,563               |   | 331                     |   |
| Commitments and  contingencies                                                                                                                                  |   |                |   |                    |   |
|                                                                                                                                                            |   |                |   |                    |   |
| Stockholders’  equity:                                                                                                                                     |   |                |   |                    |   |
| Preferred stock,  no par value, unlimited shares authorized, none issued and outstanding                                                                        |   |                |   |                    |   |
| Common stock, no  par value, unlimited shares authorized, 30,054 and 29,896 shares issued and  outstanding at March 31,2004 and December 31, 2003, respectively |   | 93,722              |   | 93,636                  |   |
| Accumulated  deficit                                                                                                                                            |   | (86,099             | )      | (85,749                 | )      |
| Accumulated  other comprehensive loss                                                                                                                           |   | (334                | )      | (331                    | )      |
| Total  stockholders’ equity                                                                                                                                |   | 7,289               |   | 7,556                   |   |
| Total  liabilities and stockholders’ equity                                                                                                                |   | $                   | 14,562 |                    | $      | 9,849 |   |

 

The accompanying notesare an integral part of the condensed consolidated financial statements.

 

3

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**PLC SYSTEMS INC.**

CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands,except per share data)

(Unaudited)

 
|                                         |   | **Three  Months Ended  March 31,** |   |
|----------------------------------------------|--------|------------------------------------|--------|
|                                         |   | **2004**                           |   | **2003** | ** ** |
| Revenues:                                    |   |                               |   |   |   |
| Product sales                                |   | $                                  | 1,531  |   | $ | 1,406 |   |
| Placement and  service fees                  |   | 378                                |   | 328 |   |
| Total revenues                               |   | 1,909                              |   | 1,734 |   |
|                                         |   |                               |   |   |   |
| Cost of  revenues:                           |   |                               |   |   |   |
| Product sales                                |   | 590                                |   | 525 |   |
| Placement and  service fees                  |   | 176                                |   | 116 |   |
| Total cost of  revenues                      |   | 766                                |   | 641 |   |
|                                         |   |                               |   |   |   |
| Gross profit                                 |   | 1,143                              |   | 1,093 |   |
|                                         |   |                               |   |   |   |
| Operating expenses:                          |   |                               |   |   |   |
| Selling, general  and administrative         |   | 990                                |   | 856 |   |
| Research and  development                    |   | 529                                |   | 241 |   |
| Total operating  expenses                    |   | 1,519                              |   | 1,097 |   |
|                                         |   |                               |   |   |   |
| Loss from  operations                        |   | (376                               | )      | (4 | ) |
|                                         |   |                               |   |   |   |
| Other income,  net                           |   | 26                                 |   | 19 |   |
|                                         |   |                               |   |   |   |
| Net income (loss)                            |   | $                                  | (350   | ) | $ | 15 |   |
|                                         |   |                               |   |   |   |
| Basic and  diluted earnings (loss) per share |   | $                                  | (.01   | ) | $ | .00 |   |
|                                         |   |                               |   |   |   |
| Average shares  outstanding:                 |   |                               |   |   |   |
| Basic                                        |   | 29,924                             |   | 29,798 |   |
| Diluted                                      |   | 29,924                             |   | 29,811 |   |

 

The accompanyingnotes are an integral part of the condensed consolidated financial statements.

 

4

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**PLC SYSTEMS INC.**

CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

 
|                                                                                          |   | **Three  Months Ended  March 31,** |   |
|-----------------------------------------------------------------------------------------------|--------|------------------------------------|--------|
|                                                                                          |   | **2004**                           |   | **2003** |   |
| Operating  activities:                                                                        |   |                               |   |   |   |
| Net income  (loss)                                                                            |   | $                                  | (350   | ) | $ | 15 |   |
|                                                                                          |   |                               |   |   |   |
| Adjustments to  reconcile net income to net cash provided by (used for) operating activities: |   |                               |   |   |   |
| Depreciation and  amortization                                                                |   | 21                                 |   | 40 |   |
| Change in assets  and liabilities:                                                            |   |                               |   |   |   |
| Accounts  receivable                                                                          |   | (144                               | )      | (289 | ) |
| Inventory                                                                                     |   | 49                                 |   | (147 | ) |
| Prepaid expenses  and other assets                                                            |   | (195                               | )      | (167 | ) |
| Accounts payable                                                                              |   | 349                                |   | 211 |   |
| Deferred revenue                                                                              |   | 4,810                              |   | 150 |   |
| Accrued  liabilities                                                                          |   | (61                                | )      | (338 | ) |
| Net cash  provided by (used for) operating activities                                         |   | 4,479                              |   | (525 | ) |
|                                                                                          |   |                               |   |   |   |
| Investing  activities:                                                                        |   |                               |   |   |   |
| Investment in  equipment                                                                      |   | (53                                | )      | — |   |
|                                                                                          |   |                               |   |   |   |
| Financing  activities:                                                                        |   |                               |   |   |   |
| Proceeds from  sales of common shares                                                         |   | 86                                 |   | — |   |
| Secured  borrowings                                                                           |   | —                             |   | (24 | ) |
| Net cash  provided by (used for) financing activities                                         |   | 86                                 |   | (24 | ) |
|                                                                                          |   |                               |   |   |   |
| Effect of  exchange rate changes on cash and cash equivalents                                 |   | (9                                 | )      | 59 |   |
| Net increase  (decrease) in cash and cash equivalents                                         |   | 4,503                              |   | (490 | ) |
|                                                                                          |   |                               |   |   |   |
| Cash and cash  equivalents at beginning of period                                             |   | 6,377                              |   | 5,932 |   |
| Cash and cash  equivalents at end of period                                                   |   | $                                  | 10,880 |   | $ | 5,442 |   |

 

The accompanying notesare an integral part of the condensed consolidated financial statements.

 

5

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**PLC SYSTEMS INC.**

NOTES TO CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS

March 31, 2004

 

***1.******             Natureof Business***

 

PLC Systems Inc. (“PLC” orthe “Company”) is a medical device company that specializes in the design,development and manufacturing of a patented carbon dioxide (CO2)laser and disposable handpieces, known as The Heart Laser System, that is usedto treat patients with severe angina in a surgical procedure known astransmyocardial revascularization, or TMR. In the United States, the Company sells its TMR products to Edwards Lifesciences.  Edwards has the exclusive right to marketand distribute the Company’s TMR products in the United States.

 

PLC’s current businessstrategy involves broadening and diversifying its product portfolio beyond itscurrent TMR offerings, by developing or acquiring new and innovative medicaldevices to address cardiac and vascular related markets. In February 2004, theCompany, consistent with this business strategy, entered into a new agreementwith Edwards to develop and manufacture a surgical cardiac ablation laserdesigned to treat cardiac arrhythmias (See Note 3).

 

Edwards is our largestshareholder, owning approximately 18% of our outstanding common stock as ofMarch 31, 2004, and has a representative on our Board of Directors.  Edwards is also our largest customer,accounting for approximately 90% and 91%, respectively, of our total sales inthe three months ended March 31, 2004 and 2003.

 

***2.******            ******Basis of Presentation***

 

The accompanyingunaudited condensed consolidated financial statements of the Company have beenprepared in accordance with generally accepted accounting principles forinterim financial information and with the instructions to Form 10-Q andArticle 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotesrequired by generally accepted accounting principles for complete financialstatements.  In the opinion ofmanagement, all adjustments (consisting of normal recurring accruals)considered necessary for a fair presentation have been included.  Operating results for the three months endedMarch 31, 2004 are not necessarily indicative of the results that may beexpected for the year ending December 31, 2004.  These financial statements should be read in conjunction with theconsolidated financial statements and footnotes thereto included in the Company’sannual report on Form 10-K for the year ended December 31, 2003.

 

***3.******             ******EdwardsTransaction***

 

In February 2004, theCompany signed an agreement with Edwards to assume development of a surgicalcardiac ablation laser system designed to treat cardiac arrhythmias. Under theterms of the agreement, the Company will have exclusive manufacturing rights tobuild the new laser system and other related surgical products. The Companywill be responsible, among other things, for ongoing research and development andmanufacture of the product and for obtaining regulatory approvals and Edwardswill be responsible for the approval, funding and conduct of any clinicalstudies designed to obtain data in support of a new product approval or

 

6

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clearanceas required by the FDA or other regulatory body.

 

In conjunction with signingthis new agreement, the terms of the Company’s TMR distribution agreement withEdwards were modified to (1) extend the term of the agreement until at leastOctober 17, 2017 and (2) reduce the Company’s share of revenue on TMR kits soldto hospitals. The Company received as consideration from Edwards a lump-sumpayment of $4,533,333, which will initially be recorded as deferred revenue inthe Company’s consolidated balance sheet.  The Company expects to amortize the $4,533,333 into its consolidatedstatement of operations as revenue over the next seven years under theunits-of-revenue method as prescribed by Emerging Issues Task Force (EITF)88-18, *Salesof Future Revenue*.

 

***4.******             Earnings (Loss) perShare***

 

In 2004, basic and dilutedloss per share have been computed using only the weighted average number ofcommon shares outstanding during the period without giving effect to anypotential future issues of common stock related to stock option programs andwarrants since their inclusion would be antidilutive.

 

In2003, basic earnings per share have been computed using only the weightedaverage number of common shares outstanding during the period, while dilutedearnings per share have been computed using the weighted average number ofcommon shares outstanding during the period plus the effect of outstandingstock options and warrants using the treasury stock method.  In calculating diluted earnings per share,the dilutive effect of stock options and warrants is computed using the averagemarket price for the respective period.

 

Forthe three months ended March 31, 2004 and 2003, 5,307,422 and 5,129,460 sharesattributable to outstanding stock options and warrants were excluded from thecalculation of diluted earnings (loss) per share because the effect wasantidilutive.  The following table setsforth the computation of basic and diluted earnings (loss) per share:

 

7

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|                                                                                                               |   | **Three  Months Ended March 31,**          |   |
|--------------------------------------------------------------------------------------------------------------------|--------|--------------------------------------------|--------|
|                                                                                                               |   | **2004**                                   |   | **2003** |   |
|                                                                                                               |   | **(In  thousands, except per share data)** |   |
| Basic:                                                                                                             |   |                                       |   |   |   |
| Net income (loss)                                                                                                  |   | $                                          | (350   | ) | $ | 15 |   |
|                                                                                                               |   |                                       |   |   |   |
| Weighted average shares outstanding                                                                                |   | 29,924                                     |   | 29,798 |   |
|                                                                                                               |   |                                       |   |   |   |
| Earnings (loss) per share                                                                                          |   | $                                          | (0.01  | ) | $ | 0.00 |   |
|                                                                                                               |   |                                       |   |   |   |
| Diluted:                                                                                                           |   |                                       |   |   |   |
| Net income (loss)                                                                                                  |   | $                                          | (350   | ) | $ | 15 |   |
|                                                                                                               |   |                                       |   |   |   |
| Weighted average shares outstanding                                                                                |   | 29,924                                     |   | 29,798 |   |
|                                                                                                               |   |                                       |   |   |   |
| Assumed impact of the exercise of outstanding dilutive stock options  and warrants using the treasury stock method |   | —                                     |   | 13 |   |
|                                                                                                               |   |                                       |   |   |   |
| Weighted average common and common equivalent shares                                                               |   | 29,924                                     |   | 29,811 |   |
|                                                                                                               |   |                                       |   |   |   |
| Earnings (loss) per share                                                                                          |   | $                                          | (0.01  | ) | $ | 0.00 |   |

 

***5.******             StockBased Compensation***

 

The Company grants stock options for a fixed number of shares toemployees and certain other individuals with exercise prices equal to the fairvalue of the shares at the dates of grant. The Company has adopted thedisclosure only provisions of Statement of Financial Accounting Standards No.123, *Accountingfor Stock-based Compensation* (“FAS 123”) as amended, and willcontinue to account for its stock option plans in accordance with theprovisions of Accounting Principles Board Opinion 25, *Accounting for Stock Issued toEmployees*.

 

The following table illustrates the effect onnet income (loss) and basic earnings (loss) per share if the Company hadapplied the fair value recognition provisions of FAS 123 to stock-basedemployee compensation:

 

8

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|                                                                                                                 |   | **Three  Months Ended March 31,**          |   |
|----------------------------------------------------------------------------------------------------------------------|--------|--------------------------------------------|--------|
|                                                                                                                 |   | **2004**                                   |   | **2003** |   |
|                                                                                                                 |   | **(In  thousands, except per share data)** |   |
| Net income  (loss) attributable to common stockholders—As reported                                              |   | $                                          | (350   | ) | $ | 15 |   |
| Deduct total  stock-based compensation expense determined under fair value based method for  all stock option awards |   | (32                                        | )      | (41 | ) |
| Net loss  attributable to common stockholders—Pro forma                                                         |   | (382                                       | )      | $ | (26 | ) |
| Earnings (loss)  per basic and diluted share attributable to common stockholders— As reported                   |   | $                                          | (0.01  | ) | $ | 0.00 |   |
| Loss per basic  and diluted share attributable to common stockholders—Pro forma                                 |   | $                                          | (0.01  | ) | $ | (0.00 | ) |

 

The fair value of options issued at the date of grantwere estimated using the Black-Scholes model with the following weightedaverage assumptions:

 
|                   |   | **Three  Months Ended  March 31,** |   |
|------------------------|--------|------------------------------------|--------|
|                   |   | **2004**                           |   | **2003** |   |
| Expected life  (years) |   | 3                                  |   | 3 |   |
| Interest rate          |   | 1.47                               | %      | 2.10 | % |
| Volatility             |   | .803                               |   | .726 |   |

 

***6.******             Comprehensive Income***

 

Total comprehensive loss for the three-month periodended March 31, 2004 amounted to $353,000, as compared to comprehensive incomeof $4,000 in the comparative 2003 period. Comprehensive income is comprised of net income (loss) plus theincrease/decrease in currency translation adjustment.

 

***7.******             Inventories***

 

Inventories arestated at the lower of cost or market using the first-in, first-out (FIFO)method and consist of the following (in thousands):

 
|             |   | **March 31,  2004** |   | **December  31,  2003** |   |
|------------------|--------|---------------------|--------|-------------------------|--------|
| Raw materials    |   | $                   | 536    |                    | $      | 668 |   |
| Work in progress |   | 190                 |   | 70                      |   |
| Finished goods   |   | 110                 |   | 147                     |   |
|             |   | $                   | 836    |                    | $      | 885 |   |

 

At March 31, 2004and December 31, 2003, inventories are stated net of a reserve of $806,000 forpotentially obsolete inventory.

 

9

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***8.******             RevenueRecognition***

 

The Company records revenuefrom the sale of TMR kits at the time of shipment to Edwards.  TMR kit revenues include the amount invoicedto Edwards for kits shipped pursuant to written purchase orders received, aswell as an amortized portion of deferred revenue related to Edwards’ lump sumTMR kit prepayment received in February 2004. The Company expects to amortize the prepayment into its consolidatedstatement of operations as revenue over the next seven years under theunits-of-revenue method as prescribed by Emerging Issues Task Force (EITF)88-18, *Salesof Future Revenue*.

 

Lasers are billed to Edwardsin accordance with purchase orders that the Company receives. Invoiced lasersare recorded as other current assets and deferred revenue on the Company’sconsolidated balance sheet until such time as the laser is shipped to ahospital, at which time the Company records revenue and cost of revenue.

 

Under the terms ofthe Edwards TMR distribution agreement, once Edwards has recovered a prescribedamount of revenue from a hospital for the use or purchase of a laser, anyadditional revenues earned by Edwards are shared with the Company pursuant to aformula established in the distribution agreement. The Company only records itsshare of such additional revenue, if any, at the time the revenue is earned.

 

The Company records revenue from the sale ofTMR kits and lasers to international distributors or hospitals at the time ofshipment.

 

Prior to enteringinto the Edwards TMR distribution agreement, the Company installed lasers inhospitals under placement contracts that did not transfer substantial ownershipof the equipment to the customer. Revenues from these transactions arerecognized over the life of the placement agreement in accordance with thespecific terms of the contract.

 

Revenues from service and maintenance contracts are recognized ratablyover the life of the contract.

 

Installation revenues related to a laser transaction are recorded as acomponent of placement and service fees when the laser is installed.

 

# ***9.****             Warranty and Preventative Maintenance Costs*

# ** **

The Company warranties itsproducts against manufacturing defects under normal use and service during thewarranty period.  The Company obtainssimilar warranties from a majority of its suppliers, including those who supplycritical Heart Laser System components. In addition, under the terms of our TMR distribution agreement withEdwards, the Company is able to bill Edwards for actual warranty costs,including preventative maintenance services, up to a specified amount duringthe warranty period.

 

The Company evaluates theestimated future unrecoverable costs of warranty and preventative maintenanceservices for its installed base of lasers on a quarterly basis and adjusts itswarranty reserve accordingly.  TheCompany considers all available evidence, including historical experience andinformation obtained from supplier audits.

 

10

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Changes in the warranty accrual were as follows (in thousands):

 
|                                                       |   | **Three  Months Ended  March 31,** |   |
|------------------------------------------------------------|--------|------------------------------------|--------|
|                                                       |   | **2004**                           |   | **2003** |   |
| Balance,  beginning of period                              |   | $                                  | 60     |   | $ | 100 |   |
| Payments made                                              |   | —                             |   | — |   |
| Change in liability  for warranties issued during the year |   | —                             |   | — |   |
| Change in  liability for preexisting warranties            |   | —                             |   | — |   |
| Balance, end of  period                                    |   | $                                  | 60     |   | $ | 100 |   |

 

**Item 2.****                       Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

 

This quarterly report (including certain informationincorporated herein by reference) contains forward-looking statements withinthe meaning of Section 27A of the Securities Act of 1933, as amended, andSection 21E of the Securities Exchange Act of 1934, as amended.  Statements containing terms such as“believes”, “plans”, “expects”, “anticipates”, “intends”, “estimates” andsimilar expressions contain uncertainty and are forward-looking statements.Forward-looking statements are based on current plans and expectations andinvolve known and unknown important risks and uncertainties that could causeactual results to differ materially from those described in the forward-lookingstatements. Such important factors and uncertainties include, but are notlimited to, those set forth below under the heading “Risk Factors” andelsewhere in this quarterly report.

 

**Application of Critical AccountingPolicies and Estimates**

 

This management’s discussion and analysis of financialcondition and results of operations is based on our condensed consolidatedfinancial statements, which have been prepared in accordance with accountingprinciples generally accepted in the United States.  Our significant accounting policies are more fully described inNote 2 of the Notes to Consolidated Financial Statements as well as in “Item 7-Management’s Discussion and Analysis of Financial Condition and Results ofOperations – Critical Accounting Policies and Estimates”, each as contained inour Annual Report on Form 10-K for the year ended December 31, 2003.  No significant changes were made to thosepolicies during the three months ended March 31, 2004, other than an additionto the Company’s revenue recognition policy to account for Edwards’ prepaymentof future TMR kit revenues in accordance with EITF 88-18, *Sales of Future Revenues*.  The Company’s revenue recognition policy hasbeen updated as follows:

 

***Revenue Recognition***

 

The Company records revenuefrom the sale of TMR kits at the time of shipment to Edwards.  TMR kit revenues include the amount invoicedto Edwards for kits shipped pursuant to written purchase orders received, aswell as an amortized portion of deferred revenue related to Edwards’ lump sumTMR kit prepayment received in February 2004. The Company expects to amortize the prepayment into its consolidatedstatement of operations as revenue over the next seven years under theunits-of-revenue method as prescribed by Emerging Issues Task Force (EITF)88-18, *Salesof Future Revenue*.

 

11

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Lasers are billed to Edwardsin accordance with purchase orders that the Company receives. Invoiced lasersare recorded as other current assets and deferred revenue on the Company’sconsolidated balance sheet until such time as the laser is shipped to a hospital,at which time the Company records revenue and cost of revenue.

 

Under the terms of theEdwards TMR distribution agreement, once Edwards has recovered a prescribedamount of revenue from a hospital for the use or purchase of a laser, anyadditional revenues earned by Edwards are shared with the Company pursuant to aformula established in the distribution agreement. The Company only records itsshare of such additional revenue, if any, at the time the revenue is earned.

 

The Company records revenue from the sale ofTMR kits and lasers to international distributors or hospitals at the time ofshipment.

 

Prior to enteringinto the Edwards TMR distribution agreement, the Company installed lasers inhospitals under placement contracts that did not transfer substantial ownershipof the equipment to the customer. Revenues from these transactions arerecognized over the life of the placement agreement in accordance with thespecific terms of the contract.

 

Revenues from service and maintenance contracts are recognized ratablyover the life of the contract.

 

Installation revenues related to a laser transaction are recorded as acomponent of placement and service fees when the laser is installed.

 

**Results of Operations**

 

Results for the three months ended March 31, 2004and March 31, 2003 and the related percent of revenues were as follows:

 
|                                   |   | **Three  Months Ended  March 31,** |   |
|----------------------------------------|--------|------------------------------------|--------|
|                                   |   | **2004**                           |   | **2003** |   |
|                                   |   | **$**                              |   | **%** |   | **$** |   | **%** |   |
|                                   |   | **(dollars  in thousands)**        |   |
| Total revenues                         |   | $                                  | 1,909  |   | 100.0 | % | $ | 1,734 |   | 100.0 | % |
| Total cost of  sales                   |   | 766                                |   | 40.1 |   | 641 |   | 37.0 |   |
| Gross profit                           |   | 1,143                              |   | 59.9 |   | 1,093 |   | 63.0 |   |
| Selling, general  & administrative |   | 990                                |   | 51.9 |   | 856 |   | 49.4 |   |
| Research &  development            |   | 529                                |   | 27.7 |   | 241 |   | 13.9 |   |
| Income (loss)  from operations         |   | (376                               | )      | (19.7 | ) | (4 | ) | (0.2 | ) |
| Other income                           |   | 26                                 |   | 1.4 |   | 19 |   | 1.1 |   |
| Net income  (loss)                     |   | $                                  | (350   | ) | (18.3 | )% | $ | 15 |   | 0.9 | % |

 

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|                                            |   | **Three  Months Ended  March 31,** |   | **Increase  (decrease)  over 2003** |   |
|-------------------------------------------------|--------|------------------------------------|--------|-------------------------------------|--------|
| **2004**                                        |   | **2003**                           |
|                                            |   | **$**                              |   | **$**                               |   | **$** |   | **%** |   |
|                                            |   | **(dollars  in thousands)**        |   |
| Product sales                                   |   | $                                  | 1,531  |                                | $      | 1,406 |   | $ | 125 |   | 9 | % |
| Placement and  service fees                     |   | 378                                |   | 328                                 |   | 50 |   | 15 |   |
| Total revenues                                  |   | 1,909                              |   | 1,734                               |   | 175 |   | 10 |   |
|                                            |   |                               |   |                                |   |   |   |   |   |
| Product cost of  sales                          |   | 590                                |   | 525                                 |   | 65 |   | 12 |   |
| Placement and  service fees cost of sales       |   | 176                                |   | 116                                 |   | 60 |   | 52 |   |
| Total cost of  revenues                         |   | 766                                |   | 641                                 |   | 125 |   | 20 |   |
|                                            |   |                               |   |                                |   |   |   |   |   |
| Gross profit                                    |   | 1,143                              |   | 1,093                               |   | 50 |   | 5 |   |
| Selling, general  & administrative expenses |   | 990                                |   | 856                                 |   | 134 |   | 16 |   |
| Research &  development expenses            |   | 529                                |   | 241                                 |   | 288 |   | 120 |   |
| Total operating  expenses                       |   | 1,519                              |   | 1,097                               |   | 422 |   | 38 |   |
| Other income                                    |   | 26                                 |   | 19                                  |   | 7 |   | 37 |   |
| Net income  (loss)                              |   | $                                  | (350   | )                                   | $      | 15 |   | $ | (365 | ) | (2,433 | )% |

 

***Product Sales***

 

Laser revenues, the largestcomponent of product sales, increased by $135,000 for the three months endedMarch 31, 2004 as compared to the three months ended March 31, 2003.  This increase is primarily attributable to a$140,000 increase in domestic laser revenues resulting from an increase in thenumber of laser units sold, coupled with increased revenue sharing earned underthe TMR distribution agreement with Edwards. This increase was offset in part by a lower average selling price ondomestic laser sales, and lower international laser revenue of $5,000.

 

Disposable TMR kit revenues,the second largest component of product sales, decreased by $34,000 for thethree months ended March 31, 2004 as compared to the three months ended March31, 2003.  This decrease is primarilyattributable to a 9% decrease in the number of TMR kits shipped to Edwards inthe first quarter of 2004 compared to 2003. In addition, in February 2004, the terms of the TMR distributionagreement were modified, reducing the Company’s share of revenue on TMR kitssold to hospitals to 36.5% of the customer generated revenue.  The impact of this reduced share in thefirst quarter was offset in part by $14,000 recognized by the Company in thefirst quarter of 2004 from the amortization of deferred TMR kit revenues.

 

Other product salesincreased $24,000 for the three months ended March 31, 2004 compared to the threemonths ended March 31, 2003.

 

***Placement and Service Fees***

 

Placement fees declined$52,000 for the three months ended March 31, 2004 as compared to the threemonths ended March 31, 2003. Approximately $35,000 of this $52,000 decline is attributable to areduction in domestic placement fees associated with the Company’s olderinstalled

 

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baseof HL1 lasers.  The remaining $17,000 ofthe $52,000 decline was the result of lower international placement contractfees due to decreased kit shipment billings to international placement contractcustomers.

 

Service fees increased$102,000 for the three months ended March 31, 2004 as compared to the threemonths ended March 31, 2003 due to more domestic lasers in service in 2004,which resulted in increased billings to Edwards for service contracts,installations and other service related calls.

 

***Gross Profit***

 

Total gross profit was$1,143,000 or 60% of total revenues for the three months ended March 31, 2004as compared with gross profit of $1,093,000 or 63% of total revenues for thethree months ended March 31, 2003.  Thehigher gross margin dollars in 2004 as compared to 2003 is due to (1) higheradditional shared revenue on laser transactions, (2) an increase in servicerelated revenues, and (3) an increase in the number of laser sold.  These increases were offset in part byreduced higher margin revenue components as follows: (1) lower average laserselling prices, (2) reduced placement fees, and (3) lower disposable TMRrevenues.

*** ***

***Selling, General and AdministrativeExpenses***

 

The overall increase of$134,000 in selling, general and administrative expenses in the three monthsended March 31, 2004 as compared to the three months ended March 31, 2003 isprimarily a result of increased expenditures related to compensation and legaland administrative fees related to the Edwards transaction.

 

***Research and Development Expenses***

 

The largest component of ourresearch and development expenses in 2004 and 2003 was the salaries andassociated fringe benefits related to our development staff.

 

The overall increase of$288,000 in research and development expenses in the three months ended March31, 2004 as compared to the three months ended March 31, 2003 is primarilyrelated to consulting expenditures incurred in the evaluation of new productdevelopment opportunities.

 

We expect to incursignificant new research and development expenditures in future quarters inpursuit of our business strategy to broaden and diversify our product portfoliobeyond our current TMR offerings. In particular, we expect our 2004 researchand development expenditures to increase approximately $2.0 million compared to2003 as we attempt to complete the development of the Optimaze System andadvance certain other longer term research and development projects.

 

***Other Income***

 

The largest component ofother income is interest income earned on our cash balances.

 

In the three months endedMarch 31, 2004, interest income remained relatively consistent compared to thethree months ended March 31, 2003.

 

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***Net Income (Loss)***

 

The Company incurred a netloss in the three months ended March 31, 2004 as compared to net income in thethree months ended March 31, 2003 due to higher operating expenses, offsetslightly by an increase in revenues.

 

There was no provision forincome tax for the three months ended March 31, 2004 or March 31, 2003, due toU.S. net operating loss carryforwards being available to reduce taxable income.

 

We expect to incur a netloss in the remaining three quarters of 2004, primarily as a result of ourplanned increased investments in research and development expenses, asdiscussed above.

 

***Kit Shipments***

 

We view disposable kitshipments to end users by Edwards as an important metric in evaluating ourbusiness.  We believe kit shipments,although not a direct measure, are a reasonable indicator for the adoption ofTMR as a therapy in the marketplace. Disposable kit shipments to end users during the three months endedMarch 31, 2004 and March 31, 2003 were as follows:

 
|          |   | **2004** |   | **% Increase  over 2003** |   | **2003** |   |
|---------------|--------|----------|--------|---------------------------|--------|----------|--------|
|          |   |     |   |                      |   |     |   |
| Domestic      |   | 382      |   | 0                         | %      | 383      |   |
| International |   | 45       |   | 50                        |   | 30       |   |
| Total         |   | 427      |   | 3                         | %      | 413      |   |

 

**Liquidity and Capital Resources**

 

At March 31, 2004, the Company had cash and cashequivalents of $10,880,000.

 

During the three-month period ended March 31, 2004,the Company recorded a net loss of $350,000. The net loss was offset by favorable working capital changes, primarilyan increase in deferred revenue (receipt of funds from Edwards) and accountspayable partly offset by prepaid expenses and other assets and inventory, whichresulted in net cash provided by operating activities of approximately$4,479,000.  Cash used in investingactivities was approximately $53,000, consisting of an investment inequipment.  Cash provided by financingactivities was approximately $86,000, consisting of proceeds from the exerciseof stock options.  The Company believesthat its existing cash resources will meet its working capital requirementsthrough the next twelve months.

 

Weare largely dependent on the success of Edwards’ sales and marketing efforts inthe U.S. to continue to increase the installed base of HL2 lasers andsubstantially increase TMR procedural volumes and revenues. Should theinstalled base of HL2 lasers or TMR procedural volume not increasesufficiently, our liquidity and capital resources will be negativelyimpacted.  Additionally, otherunanticipated decreases in operating revenues or increases in expenses orfurther changes or delays in third-party reimbursement to healthcare providersusing our products may adversely impact our cash position and require furthercost reductions or the need to obtain additional financing.  It is not certain that we, working withEdwards and our international

 

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distributors,will be successful in achieving broad commercial acceptance of the Heart LaserSystems, or that we will be able to operate profitably in the future on aconsistent basis, if at all.

 

Some hospital customers prefer to acquire the Heart Laser Systems on ausage basis rather than as a capital equipment purchase.  We believe this is the result of limitationsmany hospitals currently have on acquiring expensive capital equipment as wellas competitive pressures in the marketplace. A usage business model may result in a longer recovery period forEdwards to recoup its investment in lasers it purchases from us.  This could result in (1) a delay in ourability to receive additional shared revenue, if any, that we otherwise areentitled to receive under the terms of our distribution agreement with Edwards(see “Critical Accounting Policies and Estimates – Revenue Recognition”) and(2) a delay in the purchase of new lasers by Edwards if its installed base ofplacement lasers under usage contracts are under-performing and it chooses tore-deploy these lasers to other new hospital sites in lieu of purchasing a newlaser from us.  Our cash position andour need for additional financing to fund operations will be dependent in partupon the number of hospitals that acquire Heart Laser Systems from Edwards on ausage basis and the number and frequency of TMR procedures performed by thesehospitals.  We cannot predict whether ausage based sales model will be successful, whether implemented by us orEdwards.

 

Furthermore, we have recently undertaken a new business strategy thatinvolves broadening and diversifying our product portfolio beyond our currentTMR offerings, by developing or acquiring new and innovative medical devices toaddress cardiac and vascular related markets. We believe this strategy willresult in our incurring losses for at least the next two years as we increaseour investments in both manufacturing and research and development staff andcapital equipment necessary to pursue these new strategic initiatives,including, but not limited to, the Optimaze System. We expect our 2004 capitalexpenditures to be in the range of $500,000 to $600,000.  We cannot be certain that we will besuccessful in implementing our new business strategy or that future sales, ifany, from these planned new products will recover the investments we plan tomake. If we are unsuccessful in implementing our new business strategy, ourliquidity and capital resources will be adversely affected and we may need toobtain additional financing.

 

Therecan be no assurance that, should we require additional financing, suchfinancing will be available on terms and conditions acceptable to us.  Should additional financing not be availableon terms and conditions acceptable to us, additional actions may be requiredthat could adversely impact our ability to continue to realize assets andsatisfy liabilities in the normal course of business.  The condensed consolidated financial statements set forth in thisquarterly report do not include any adjustments to reflect the possible futureeffects of these uncertainties.

 

**Off-Balance Sheet Arrangements**

 

None.

 

## **CertainFactors that May Affect our Future Results**

## ** **

The risks and uncertaintiesdescribed below are not the only risks we face.  Additional risks and uncertainties not presently known to us orcurrently deemed immaterial may also impair our business operations.  If any of the following risks actuallyoccur, our financial condition and operating results could be materiallyadversely affected.

 

16

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***Our company has a limited recenthistory of operating profits and we expect to incur significant operatinglosses in the near future***

 

Weincurred a net loss in the quarter ended March 31, 2004.  We expect to increase our spendingsignificantly in 2004 in the areas of manufacturing and research anddevelopment as we increase our manufacturing capabilities and development staffto work on the Optimaze System. Moreover, as we continue to pursue our newbusiness strategy of acquiring or developing new medical devices to addresscardiac and vascular related markets, we may continue to incur expenses that exceedthe revenues we generate.  We cannotprovide any assurance that we will be successful with our new business strategyor that we will ever return to profitability.

 

***Our company is currently dependenton one principal product line to generate revenues***

 

Wecurrently market one principal product line, which consists of two patentedhigh-powered carbon dioxide lasers and related TMR disposable kits known as theHeart Laser Systems.  Approximately 94%and 95% of our revenues in the three months ended March 31, 2004 and in theyear ended December 31, 2003, respectively, were derived from the sales andservice of our Heart Laser Systems. This absence of a diversified product line means that we are directlyand materially impacted by changes in the market for Heart Laser Systems.

 

***Our company is dependent on one principalcustomer***

 

Pursuant to the terms of ourTMR distribution agreement with Edwards, Edwards is our exclusive distributorfor our HL2 and TMR kits in the United States. In addition, pursuant to the terms of our new distribution agreementwith Edwards for the Optimaze System (as well as any other additional surgicalproducts that we may develop for the treatment of atrial fibrillation, referredto as AF, or atrial flutter), Edwards is our exclusive worldwide distributor ofthose products.  As a result of the TMRrelationship, Edwards accounted for 90% and 89% of our total revenue in thethree months ended March 31, 2004 and the year ended December 31, 2003, respectively,and we expect Edwards to account for the significant majority of our revenue inthe future.  If our relationship withEdwards does not progress as anticipated, or if Edwards’ sales and marketingstrategies fail to generate sales of our products in the future, our revenuewill decrease significantly and our business, financial condition and resultsof operations will be seriously harmed.

 

***Our company is dependent on certain suppliers***

 

Some of the components for our Heart Laser Systems, most notably thepower supply and certain optics and fabricated parts for the HL2, and certaincomponents for the Optimaze System, are only available from one supplier, andwe have no assurance that we will be able to source any of our sole-sourcedcomponents from additional suppliers. We are dependent upon our sole suppliers to perform their obligations ina timely manner.  In the past, we haveexperienced delays in product delivery from our sole suppliers and, because wedo not have an alternative supplier to produce these products for us, we havelittle leverage to enforce timely delivery. Any delay in product delivery orother interruption in supply from these suppliers could prevent us from meetingour commercial demands for our products, which could have a material adverseeffect on our business, financial condition and results of operations.  Furthermore, we do not require significantquantities of any components because we produce a limited number of ourproducts each year.  Our low-quantityneeds may not generate substantial revenue for our suppliers.  Therefore, it may be difficult for us tocontinue our relationships with

 

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our current suppliers or establish relationships with additionalsuppliers on commercially reasonable terms, if at all, and such difficultiesmay seriously harm our business, financial condition and results of operations.

 

***We must complete development of theOptimaze System and be able to manufacture it in required volumes atcommercially reasonable costs***

 

We must successfully complete development ofthe Optimaze System.  We expect tooutfit our facility with the necessary production and test equipment and trainour employees on how to build the product. This will include the need to manufacturehighly specialized disposable handpieces for which we have no comparable priorexperience producing at any volume. Until such time as we become more proficient in these manufacturingmethods, if ever, we may encounter problems related to:

 

•                  production yields;

•                  quality control;

•                  training;

•                  shortages of qualified personnel; and

•                  potential capacity constraints.

 

Such problems could severely affect ourability to adequately scale up production and meet demand for our products on atimely basis, which could harm our business, financial condition and results ofoperations.

 

***We are dependent upon our key personnel and will need to hireadditional key personnel in the near future***

 

Our ability to operate our businesssuccessfully depends in significant part upon the retention and motivation ofcertain key technical, regulatory, production and managerial personnel and ourongoing ability to hire and retain additional qualified personnel in theseareas. Competition for such personnel is intense, particularly in the GreaterBoston area. We cannot be certain that we will be able to attract suchpersonnel and the loss of any of our current key employees could have asignificant adverse impact on our business.

 

***Our company may be unable to raiseneeded funds***

 

Asof March 31, 2004, we had cash and cash equivalents totaling $10,880,000 whichincludes $4,533,333 received in a February 2004 transaction with Edwards.  Based on our current operating plan, weanticipate that our existing capital resources should be sufficient to meet ourworking capital requirements for at least the next 12-24 months.  However, if our business does not progressin accordance with our current business plan, we may need to raise additionalfunds in the future.  We may not be ableto raise additional capital upon satisfactory terms, or at all, and ourbusiness, financial condition and results of operations could be materially andadversely affected.  To the extent thatwe raise additional capital by issuing equity or convertible securities,ownership dilution to our stockholders will result.  To the extent that we raise additional capital through theincurrence of debt, our activities may be restricted by the repaymentobligations and other restrictive covenants related to the debt.

 

18

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***In order to compete effectively, ourcurrent and future products need to gain commercial acceptance***

 

TMRand surgical ablation for cardiac arrhythmias are still both emergingtechnologies.  Our current and plannedfuture products may never achieve widespread commercial acceptance.  To be successful, we need to:

 

•                  demonstrate to the medical community ingeneral, and to heart surgeons and cardiologists in particular, that TMR andsurgical tissue ablation for cardiac arrhythmias are procedures that are effective,relatively safe and cost effective;

 

•                  support third-party efforts to document themedical processes by which TMR procedures relieve angina and surgical tissueablation cures cardiac arrhythmias;

 

•                  have more heart surgeons trained to performTMR procedures using the Heart Laser Systems and surgical tissue ablationprocedures using the Optimaze System, assuming the latter becomes commerciallyavailable in the future; and

 

•                  maintain third-party reimbursement for boththe TMR procedure and the use of surgical tissue ablation for the treatment ofcardiac arrhythmias.

 

Todate, only a limited number of heart surgeons have been trained in the use ofTMR, and we are dependent on Edwards to expand related marketing and trainingefforts in the U.S. for the use of our current and planned future products.

 

Althoughthe Heart Laser Systems have received FDA approval and the CE Mark, they havenot yet received widespread commercial acceptance.  In addition, although the Optimaze System has received FDAclearance, it has not yet secured the CE Mark and it is not yet ready forwidespread commercialization. If we are unable to maintain regulatoryclearances, secure the CE Mark for the Optimaze System or achieve widespreadcommercial acceptance of the Heart Laser Systems or the Optimaze System, ourbusiness, financial condition and results of operations will be materially andadversely affected.

 

***Our competitor in TMR may obtain FDAapproval to market a new device, the impact of which is uncertain on the futureadoption rate of TMR***

 

Our primary TMR competitor,CardioGenesis, is attempting to obtain FDA approval to market their“percutaneous” method of performing myocardial revascularization, known as PMR,which would provide a less invasive method of creating channels in theheart.  If PMR can be shown to be safe and effective and is approved bythe FDA, it would eliminate the need in certain patients to make an incision inthe chest, reducing costs and speeding recovery.  It is unclear what impact, if any, an approval of a PMR devicewould have on the future adoption rate for TMR procedures.  If PMR is approved, it could erode thepotential TMR market which would have a material adverse effect on ourbusiness, financial condition and results of operations.

 

***Rapid technological changes in ourindustry could make our products obsolete***

 

Ourindustry is characterized by rapid technological change and intensecompetition.  New technologies andproducts and new industry standards will develop at a rapid pace, which couldmake our current and future planned products obsolete. The advent of newdevices and

 

19

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proceduresand advances in new drugs and genetic engineering are especiallythreatening.  Our future success willdepend upon our ability to develop and introduce product enhancements toaddress the needs of our customers. Material delays in introducing product enhancements may cause customersto forego purchases of our product and purchase those of our competitors.

 

Manypotential competitors have substantially greater financial resources and are ina better financial position to exploit marketing and research and developmentopportunities.  In addition, we areaware that other companies are developing or already have developed proprietarysystems for the treatment of cardiac arrhythmias, and specifically AF, that maybe safer, clinically more effective, easier and more cost effective to use and,in the case of percutaneous devices, less invasive than the system we plan to develop.

 

***We must receive and maintaingovernment clearances or approvals in order to market our products***

 

Ourproducts and our manufacturing activities are subject to extensive, rigorousand changing federal and state regulation in the U.S. and to similar regulatoryrequirements in other major international markets, including the European Unionand Japan.  These regulations andregulatory requirements are broad in scope and govern, among other things:

 

•                  product design and development;

•                  product testing;

•                  product labeling;

•                  product storage;

•                  premarket clearance and approval;

•                  advertising and promotion; and

•                  product sales and distribution.

 

Furthermore,regulatory authorities subject a marketed product, its manufacturer and themanufacturing facilities to continual review and periodic inspections.  We will be subject to ongoing FDArequirements, including required submissions of safety and other post-marketinformation and reports, registration requirements, Quality Systemsregulations, and recordkeeping requirements. The FDA’s Quality Systems regulations include requirements relating toquality control and quality assurance, as well as the corresponding maintenanceof records and documentation.  Edwards,our distributor, depending on its activities, is also subject to certainrequirements under the Federal Food, Drug, and Cosmetic Act and the regulationspromulgated thereunder, and state laws and registration requirements coveringthe distribution of our products. Regulatory agencies may change existing requirements or adopt newrequirements or policies that could affect our regulatory responsibilities orthe regulatory responsibilities of a distributor like Edwards.  We may be slow to adapt or may not be ableto adapt to these changes or new requirements.

 

Laterdiscovery of previously unknown problems with our products, manufacturingprocesses, or our failure to comply with applicable regulatory requirements mayresult in enforcement actions by the FDA and other international regulatoryauthorities, including, but not limited to:

 

•                  warning letters;

•                  patient or physician notification;

•                  restrictions on our products or manufacturingprocesses;

 

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•                  voluntary or mandatory recalls;

•                  product seizures;

•                  refusal to approve pending applications orsupplements to approved applications that we submit;

•                  refusal to permit the import or export of ourproducts;

•                  fines;

•                  injunctions;

•                  suspension or withdrawal of marketingapprovals or clearances; and

•                  civil and criminal penalties.

 

Shouldany of these enforcement actions occur, our business, financial condition andresults of operations could be materially and adversely affected.

 

Todate, we have received the following regulatory approvals for our products:

 

***Heart Laser Systems***

 

*United States —*We received FDA approval to market the HL1 Heart Laser System in August1998 and the HL2 Heart Laser System in January 2001.  However, although we have received FDA approval, the FDA:

 

•                  has restricted the use of the Heart LaserSystems by not allowing us to market these products to treat patients whosecondition is amenable to conventional treatments, such as heart bypass surgery,stenting and angioplasty; and

 

•                  could impose additional restrictions orreverse its ruling and prohibit use of the Heart Laser Systems at any time.

 

*Europe —*Although we have the ability to market our Heart Laser System in theEuropean Union, individual members of the European Union could prohibit, andFrance has prohibited, commercial use of the Heart Laser Systems.

 

Wereceived the CE Mark from the European Union for the HL1 and HL2 in March 1995and February 2001, respectively. However:

 

•                  the European Union could impose additionalrestrictions or reverse its ruling and prohibit use of the Heart Laser Systemsat any time; and

 

•                  other European Union countries could prohibitor restrict use of the Heart Laser Systems.

 

*Japan —*We cannot market our product in Japan until we receive governmentapproval.

 

Webelieve that Japan represents the largest potential market for the Heart LaserSystems in Asia.  Prior to marketing theHeart Laser Systems in Japan, we must receive approval from the Japanesegovernment.  This approval requires aclinical study in Japan with at least 60 patients.  A study was completed in 1998 with the HL1. Although the resultsof this study have been submitted to the Japanese government, we do not knowwhether the clinical study will be sufficient or when, if ever, we will receiveapproval to sell the HL1 in Japan.  Inaddition, it is

 

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unclearwhat impact the introduction of the HL2 into the U.S. and other internationalmarkets will have on our ability to market the HL1 in Japan.

 

***Optimaze System***

 

*United States —*The FDA has given clearance to the OptimazeSystem through the 510(k) premarket notification process with indications foruse as a surgical instrument for coagulation of soft tissue, including cardiactissue, in conjunction with or without endoscopic equipment in the contact ornon contact mode in open or closed surgical procedures.  However, as the Optimaze System is stillbeing developed, it is not yet deemed ready for commercial use in the U.S.

 

In addition, although we have received clearance from the FDA only for theindications of use stated above, physicians, under the practice of medicineexception, may use the Optimaze System in any manner they choose in treating anindividual patient, including using the device to treat patients with AF.  However, neither we nor Edwards haveconducted any clinical trials designed to obtain data to submit to the FDA forthe purpose of obtaining a specific indication for use of the Optimaze Systemthat would allow us to make claims or otherwise market this device for thetreatment of AF. We are aware of at least one company which has indicated theyhave submitted data to the FDA in support of a labeling claim that, ifclearance is obtained, would allow them to market their device for thetreatment of AF.

 

In the event this company or other competitors are successful inobtaining specific indications of use for their devices in the treatment of AF,our cardiac ablation products and specifically the Optimaze System may be at acompetitive marketing disadvantage until such time, if ever, that Edwardsconducts a clinical trial, submits sufficient data to the FDA by means of a new510(k) and obtains clearance to market the Optimaze System for the treatment ofAF. We cannot provide any assurance that Edwards will ever conduct such a clinicaltrial or, if they do, that the data they obtain and submit to the FDA will besufficient for the FDA to expand the current indications of use and provideclearance for the Optimaze System to be marketed for the treatment of AF. Also,we cannot assure you that even if such clearance is obtained, that it will beobtained in a timely enough fashion for our products to remain competitive inthe marketplace.

 

*Europe —*Once the Optimaze System is fully developed in accordance with ourinternal design control processes and we deem it ready for human use, itnevertheless cannot be marketed in the EU until such time as it receives CEMark approval. We need to complete and submit the relevant technicaldocumentation to the appropriate certifying body in order to be able to applythe CE Mark that, if granted, will enable the product to be distributed in theEU.

 

***Changes in third party reimbursementfor our TMR procedure could materially affect future demand for our TMRproducts***

 

Currently Medicare coverageis provided for TMR when it is performed as both a sole therapy treatment andwhen used as an adjunct to bypass surgery. Certain private insurancecompanies and health maintenance organizations also currently providereimbursement for TMR procedures performed with our products and physician reimbursement codes have beenestablished for both surgical procedures; however we have limited data as tothe breadth of this coverage for the TMR procedure by private insurancecompanies and health maintenance organizations.

 

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No assurance can be given, however, that these payerswill continue to reimburse healthcare providers who perform TMR using ourproducts now or in the future.  Inaddition, the market for our products could be adversely affected by futurelegislation to reform the nation’s healthcare system or by changes in industrypractices regarding reimbursement policies and procedures. Should third partyinsurance reimbursement for our TMR products be reduced or eliminated in thefuture, our business, financial condition and results of operations could bematerially and adversely affected.

 

***Asserting and defending intellectualproperty rights may impact our results of operations***

 

Inour industry, competitors often assert intellectual property infringementclaims against one another.  The successof our business depends on our ability to successfully defend our intellectualproperty.  Future litigation may have amaterial impact on our financial condition even if we are successful inmarketing our products. We may not be successful in defending or asserting ourintellectual property rights.

 

Anadverse outcome in any litigation or interference proceeding could subject usto significant liabilities to third parties and require us to cease using thetechnology that is at issue or to license the technology from thirdparties.  In addition, a finding thatany of our intellectual property is invalid could allow our competitors to moreeasily and cost-effectively compete with us. Thus, an unfavorable outcome in any patent litigation or interferenceproceeding could have a material adverse effect on our business, financialcondition or results of operations.

 

Thecost to us of any patent litigation or interference proceeding could besubstantial.  Uncertainties resultingfrom the initiation and continuation of patent litigation or interferenceproceedings could have a material adverse effect on our ability to compete inthe marketplace.  Patent litigation andinterference proceedings may also absorb significant management time.

 

***We may be subject to productliability lawsuits; our insurance may not be sufficient to cover damages***

 

Wemay be subject to product liability claims. The United States Supreme Court has stated that compliance with FDAregulations will not shield a company from common law negligent design claimsor manufacturing and labeling claims based on state rules.  Such claims may absorb significantmanagement time and could degrade our reputation and the marketability of ourproducts.  If product liability claimsare made with respect to our products, we may need to recall the implicatedproduct which could have a material adverse effect on our business, financialcondition and results of operations. In addition, although we maintain productliability insurance, we cannot be sure that our insurance will be adequate tocover potential product liability lawsuits. Our insurance is expensive and in the future may not be available onacceptable terms, if at all. If a successful product liability claim or seriesof claims exceeds our insurance coverage, it could have a material adverseeffect on our business, financial condition and results of operations.

 

***We are subject to risks associatedwith international operations***

 

Aportion of our product sales are generated from operations outside of theU.S.  Establishing, maintaining andexpanding international sales can be expensive.  Managing and overseeing foreign operations may be difficult andproducts may not receive market acceptance.

 

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Risksof doing business outside the U.S. include, but are not limited to, thefollowing: agreements may be difficult to enforce and receivables difficult tocollect through a foreign country’s legal system; foreign customers may havelonger payment cycles; foreign countries may impose additional withholdingtaxes or otherwise tax our foreign income, impose tariffs or adopt otherrestrictions on foreign trade; U.S. export licenses may be difficult to obtain;and the protection of intellectual property in foreign countries may be moredifficult to enforce.  There can be noassurance that our international business will grow or that any of theforegoing risks will not result in a material adverse effect on our business orresults of operations.

 

***Because we are incorporated inCanada, you may not be able to enforce judgments against us and our Canadiandirectors***

 

UnderCanadian law, you may not be able to enforce a judgment issued by courts in theU.S. against us or our Canadian directors. The status of the law in Canada isunclear as to whether a U.S. citizen can enforce a judgment from a U.S. courtin Canada for violations of U.S. securities laws. A separate suit may need tobe brought directly in Canada.

 

***Our stock price has historicallyfluctuated and may continue to fluctuate significantly in the future which mayresult in losses for our investors***

 

Ourstock price has been and may continue to be volatile. Some of the factors thatcan affect our stock price are:

 

•                  the announcement of new products, services ortechnological innovations by us or our competitors;

•                  actual or anticipated quarterly increases ordecreases in revenue, gross margin or earnings, and changes in our business,operations or prospects;

•                  speculation or actual news announcements inthe media or industry trade journals about our company, our products, the TMRprocedure or changes in reimbursement policies by Medicare and/or privateinsurance companies;

•                  announcements relating to strategicrelationships or mergers;

•                  conditions or trends in the medical deviceindustry;

•                  changes in the economic performance or marketvaluations of other medical device companies; and

•                  general market conditions or domestic orinternational macroeconomic and geopolitical factors unrelated to ourperformance.

 

***The market price of our stock mayfall if shareholders sell their stock***

 

Certain current shareholdershold large amounts of our stock, which they could sell in the public marketfrom time to time.  Sales of asubstantial number of shares of our common stock within a short period of timecould cause our stock price to fall.  Inaddition, the sale of these shares could impair our ability to raise capitalthrough the sale of additional stock.

 

***We have no intention to pay dividends***

 

We have never paid any cashdividends on our common stock. We currently intend to retain all futureearnings, if any, for use in our business and do not expect to pay anydividends in the foreseeable future.

 

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**Item 3.****    Quantitative and QualitativeDisclosures About Market Risk**

 

A portion of our operations consists of salesactivities in foreign jurisdictions.  Wemanufacture our products exclusively in the U.S. and sell our products in theU.S. and abroad. As a result, our financial results could be affected byfactors such as changes in foreign currency exchange rates or weak economicconditions in the foreign markets in which we distribute our products.  Our operating results are exposed to changesin exchange rates between the U.S. dollar and foreign currencies, especiallythe Swiss Franc and the Euro. When the U.S. dollar strengthens against theFranc or Euro, the value of foreign sales decreases. When the U.S. dollar weakens,the functional currency amount of sales increases. No assurance can be giventhat foreign currency fluctuations in the future may not adversely affect ourbusiness, financial condition and results of operations, although at thepresent we do not believe that our exposure is significant.

 

The Company does not hedge any balance sheet exposuresand intercompany balances against future movements in foreign exchangerates.  We do not believe that a 10%change to the applicable exchange rates would have a material impact on ourfuture results of operations or cash flows.

 

Our interest income is sensitive to changes in thegeneral level of U.S. and foreign interest rates. In this regard, changes inU.S. and foreign interest rates affect the interest earned on our cash and cashequivalents.  We do not believe that a10% change to interest rates would have a material impact on our future resultsof operations or cash flows.

 

## **Item 4.**    Controls and Procedures

## ** **

Ourmanagement, with the participation of our Chief Executive Officer, or CEO, andChief Financial Officer, or CFO, evaluated the effectiveness of our disclosurecontrols and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under theSecurities Exchange Act) as of March 31, 2004. Based on this evaluation, ourCEO and CFO concluded that, as of March 31, 2004, our disclosure controls andprocedures were (1) designed to ensure that material information relating tous, including our consolidated subsidiaries, is made known to our CEO and CFOby others within those entities, particularly during the period in which thisreport was being prepared and (2) effective, in that they provide reasonableassurance that information required to be disclosed by us in the reports thatwe file or submit under the Securities Exchange Act is recorded, processed,summarized and reported within the time periods specified in the Securities andExchange Commission’s rules and forms.

 

No change in our internalcontrol over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f)under the Securities Exchange Act) occurred during the fiscal quarter endedMarch 31, 2004 that has materially affected, or is reasonably likely tomaterially affect, our internal control over financial reporting.

 

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# **Part II.  Other Information**

# ** **

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

 

a)             Exhibits

 
| 10.1+  | Distribution  Agreement by and among PLC Systems Inc., PLC Medical Systems, Inc. and  Edwards Lifesciences LLC dated February 24, 2004.                                                                |
|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                   |
| 10.2+  | Contribution,  Development and Manufacturing Agreement by and among PLC Systems Inc., PLC  Medical Systems, Inc. and Edwards Lifesciences LLC dated as of February 24,  2004.                          |
|   |                                                                                                                                                                                                   |
| 10.3   | First  Amendment to Shareholders Agreement entered into as of February 24, 2004 by  and between Edwards Lifesciences Corporation and PLC Systems Inc.                                                  |
|   |                                                                                                                                                                                                   |
| 10.4   | First  Amendment to Distribution Agreement entered into as of February 24, 2004 by  and among Edwards Lifesciences LLC, PLC Systems Inc. and PLC Medical Systems,  Inc.                                |
|   |                                                                                                                                                                                                   |
| 31.1   | Certification of Chief  Executive Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the  Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002. |
|   |                                                                                                                                                                                                   |
| 31.2   | Certification of Chief  Financial Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) of the  Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002. |
|   |                                                                                                                                                                                                   |
| 32.1   | Certification pursuant  to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                                              |

 

b)            Reportson Form 8-K

 

The Company filed aCurrent Report on Form 8-K on February 25, 2004 announcing that it had enteredinto an exclusive, multi-year agreement with Edwards Lifesciences Corporationto develop and manufacture Edwards’ Optimaze surgical ablation system.

 

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**SIGNATURES**

 

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

 

 
|   |         | PLC SYSTEMS INC. |
|--------|--------------|------------------|
|   |         |             |   |
|   |         |             |   |
| Date:  | May 11, 2004 | By:              | /s/ James G. Thomasch |   |
|   |         |             | James G. Thomasch |
|   |         |             | Chief Financial Officer |
|   |         |             | (Principal Financial Officer and Chief Accounting  Officer) |
|        |              |                  |  |  |  |

 

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**EXHIBITINDEX**

 
| **Exhibit**Number |   | **Description  of Document**                                                                                                                                                                      |
|-------------------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|              |   |                                                                                                                                                                                              |
| 10.1+             |   | Distribution  Agreement by and among PLC Systems Inc., PLC Medical Systems, Inc. and  Edwards Lifesciences LLC dated February 24, 2004.                                                           |
|              |   |                                                                                                                                                                                              |
| 10.2+             |   | Contribution,  Development and Manufacturing Agreement by and among PLC Systems Inc., PLC  Medical Systems, Inc. and Edwards Lifesciences LLC dated as of February 24,  2004.                     |
|              |   |                                                                                                                                                                                              |
| 10.3              |   | First  Amendment to Shareholders Agreement entered into as of February 24, 2004 by  and between Edwards Lifesciences Corporation and PLC Systems Inc.                                             |
|              |   |                                                                                                                                                                                              |
| 10.4              |   | First  Amendment to Distribution Agreement entered into as of February 24, 2004 by  and among Edwards Lifesciences LLC, PLC Systems Inc. and PLC Medical Systems,  Inc.                           |
|              |   |                                                                                                                                                                                              |
| 31.1              |   | Certification  of Chief Executive Officer pursuant to Rule 13a-14(a) or 15d-14(a) of the  Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002. |
|              |   |                                                                                                                                                                                              |
| 31.2              |   | Certification  of Chief Financial Officer pursuant to Rule 13a-14(a) or 15d-14(a) of the  Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002. |
|              |   |                                                                                                                                                                                              |
| 32.1              |   | Certification  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                                         |

 

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+                 Confidential treatment has been requested forcertain portions of this Exhibit pursuant to Rule 406 promulgated under theSecurities Act of 1933, as amended, which portions are omitted and filedseparately with the Securities and Exchange Commission.

 

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