**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

** **

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**FORM 10-Q**

** **

**x****                     ****QUARTERLY REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.**

**For the quarterly period ended June 30, 2006.**

**OR**

**o****                        ****TRANSITION REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.**

**For thetransition period from               to           **

Commission File Number: **1-11388**

**PLC SYSTEMS INC.**

*(Exact Name of Registrant as Specified in ItsCharter)*

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

 

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

Indicate by checkmark whether 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 x   No o

Indicate by check mark whether the registrant is a large acceleratedfiler, an accelerated filer, or a non-accelerated filer.  See definition of “accelerated filer andlarge accelerated filer” in Rule 12b-2 of the Exchange Act.  (Check one):

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

 

Indicate by check mark whether the registrant is a shell company (asdefined in Rule 12b-2 of the Exchange Act) Yes o   No x

Indicate thenumber of shares outstanding of each of the issuer’s classes of common stock,as of the latest practicable date.

| Class                       | ** ** | **Outstanding at August 4, 2006** | ** ** |
|-----------------------------|------------|-------------------------------------------------------|------------|
| Common Stock, no  par value |       | 30,237,436                                            |       |

 

 

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**PLC SYSTEMS INC.**

**Index**
| Part I.   Financial  Information: |   |                                                                                        |   |
|---------------------------------------------|--------|---------------------------------------------------------------------------------------------|--------|
|                                        |   |                                                                                        |   |   |   |
| Item 1.                                     |   | Financial  Statements                                                                       |   |   |   |
|                                        |   |                                                                                        |   |   |   |
|                                        |   | Condensed  Consolidated Balance Sheets (unaudited)                                          |   | 3 |   |
|                                        |   |                                                                                        |   |   |   |
|                                        |   | Condensed Consolidated Statements of Operations  (unaudited)                                |   | 4 |   |
|                                        |   |                                                                                        |   |   |   |
|                                        |   | Condensed Consolidated Statements of Cash Flows  (unaudited)                                |   | 5 |   |
|                                        |   |                                                                                        |   |   |   |
|                                        |   | Notes to Condensed Consolidated Financial Statements  (unaudited)                           |   | 6 |   |
|                                        |   |                                                                                        |   |   |   |
| Item 2.                                     |   | Management’s Discussion and Analysis of Financial  Condition and Results of Operations |   | 14 |   |
|                                        |   |                                                                                        |   |   |   |
| Item 3.                                     |   | Quantitative and Qualitative Disclosures about Market  Risk                                 |   | 23 |   |
|                                        |   |                                                                                        |   |   |   |
| Item 4.                                     |   | Controls and Procedures                                                                     |   | 23 |   |
|                                        |   |                                                                                        |   |   |   |
| Part  II.   Other  Information:   |   |                                                                                        |   |
|                                        |   |                                                                                        |   |   |   |
| Item  1A.                                   |   | Risk  Factors                                                                               |   | 24 |   |
|                                        |   |                                                                                        |   |   |   |
| Item 4.                                     |   | Submission of Matters to a Vote of Security Holders                                         |   | 33 |   |
|                                        |   |                                                                                        |   |   |   |
| Item 6.                                     |   | Exhibits                                                                                    |   | 33 |   |

2

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**Part I.     Financial Information**

**Item 1.**                          FinancialStatements

**PLCSYSTEMS INC.**CONDENSED CONSOLIDATED BALANCE SHEETS(In thousands)(Unaudited)
| ** **                                                                                                                                                         | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| **ASSETS**                                                                                                                                                         | ** ** | ** **              | ** ** | ** **                  | ** ** |
| Current assets:                                                                                                                                                    |       |                    |       |                        |       |
| Cash and cash equivalents                                                                                                                                          |       | $                       | 4,896      |                        | $          | 2,560 |   |
| Short-term investments                                                                                                                                             |       | 5,500                   |       | 6,900                       |       |
| Accounts receivable — Edwards                                                                                                                                 |       | 1,168                   |       | 634                         |       |
| Accounts receivable — other, net of allowance of $97  and $96 as of June 30, 2006 and December 31, 2005, respectively                                         |       | 134                     |       | 153                         |       |
| Inventories, net                                                                                                                                                   |       | 986                     |       | 963                         |       |
| Prepaid expenses and other current assets                                                                                                                          |       | 742                     |       | 798                         |       |
| Total current assets                                                                                                                                               |       | 13,426                  |       | 12,008                      |       |
|                                                                                                                                                               |       |                    |       |                        |       |
| Equipment,  furniture and leasehold improvements, net                                                                                                              |       | 137                     |       | 235                         |       |
| Other assets                                                                                                                                                       |       | 216                     |       | 224                         |       |
| Total assets                                                                                                                                                       |       | $                       | 13,779     |                        | $          | 12,467 |   |
|                                                                                                                                                               |       |                    |       |                        |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                     |       |                    |       |                        |       |
| Current liabilities:                                                                                                                                               |       |                    |       |                        |       |
| Accounts payable                                                                                                                                                   |       | $                       | 447        |                        | $          | 352 |   |
| Accrued compensation                                                                                                                                               |       | 543                     |       | 677                         |       |
| Accrued other                                                                                                                                                      |       | 316                     |       | 334                         |       |
| Deferred revenue — Edwards                                                                                                                                    |       | 1,830                   |       | 1,621                       |       |
| Deferred revenue — other                                                                                                                                      |       | 56                      |       | 60                          |       |
| Total current liabilities                                                                                                                                          |       | 3,192                   |       | 3,044                       |       |
| Deferred revenue — Edwards                                                                                                                                    |       | 3,341                   |       | 3,692                       |       |
| Deferred revenue — other                                                                                                                                      |       | 188                     |       | 188                         |       |
| Total long-term liabilities                                                                                                                                        |       | 3,529                   |       | 3,880                       |       |
| 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, 30,237 and 30,080 shares issued and  outstanding as of June 30, 2006 and December 31, 2005, respectively |       | 93,845                  |       | 93,737                      |       |
| Additional paid  in capital                                                                                                                                        |       | 33                      |       | —                      |       |
| Accumulated  deficit                                                                                                                                               |       | (86,487                 | )          | (87,850                     | )          |
| Accumulated  other comprehensive loss                                                                                                                              |       | (333                    | )          | (344                        | )          |
| Total stockholders’ equity                                                                                                                                    |       | 7,058                   |       | 5,543                       |       |
| Total  liabilities and stockholders’ equity                                                                                                                   |       | $                       | 13,779     |                        | $          | 12,467 |   |

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

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**PLCSYSTEMS INC.**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS(In thousands, except per share data)(Unaudited)
| ** **                                | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| Revenues:                                 |       |                                            |       |                                          |       |   |   |   |   |
| Product sales — Edwards              |       | $                                               | 1,426      |                                          | $          | 1,438 |   | $ | 2,602 |   | $ | 2,846 |   |
| Product sales — other                |       | 151                                             |       | 129                                           |       | 455 |   | 279 |   |
| Service fees — Edwards               |       | 333                                             |       | 360                                           |       | 697 |   | 671 |   |
| Service fees — other                 |       | 33                                              |       | 55                                            |       | 78 |   | 129 |   |
| Total revenues                            |       | 1,943                                           |       | 1,982                                         |       | 3,832 |   | 3,925 |   |
| Cost of revenues:                         |       |                                            |       |                                          |       |   |   |   |   |
| Product sales — Edwards              |       | 464                                             |       | 531                                           |       | 827 |   | 1,016 |   |
| Product sales — other                |       | 90                                              |       | 69                                            |       | 238 |   | 136 |   |
| Service fees — Edwards               |       | 129                                             |       | 144                                           |       | 271 |   | 282 |   |
| Service fees — other                 |       | 39                                              |       | 46                                            |       | 77 |   | 84 |   |
| Total cost of revenues                    |       | 722                                             |       | 790                                           |       | 1,413 |   | 1,518 |   |
| Gross profit                              |       | 1,221                                           |       | 1,192                                         |       | 2,419 |   | 2,407 |   |
| Operating expenses:                       |       |                                            |       |                                          |       |   |   |   |   |
| Selling, general and administrative       |       | 804                                             |       | 897                                           |       | 1,684 |   | 1,777 |   |
| Research and development                  |       | 458                                             |       | 649                                           |       | 991 |   | 1,220 |   |
| Total operating expenses                  |       | 1,262                                           |       | 1,546                                         |       | 2,675 |   | 2,997 |   |
| Gain on the sale  of manufacturing rights |       | —                                          |       | —                                        |       | 1,432 |   | — |   |
| Income (loss)  from operations            |       | (41                                             | )          | (354                                          | )          | 1,176 |   | (590 | ) |
| Other income,  net                        |       | 113                                             |       | 64                                            |       | 187 |   | 116 |   |
| Net income  (loss)                        |       | $                                               | 72         |                                          | $          | (290 | ) | $ | 1,363 |   | $ | (474 | ) |
| Basic income  (loss) per share            |       | $                                               | 0.00       |                                          | $          | (0.01 | ) | $ | 0.05 |   | $ | (0.02 | ) |
| Diluted income  (loss) per share          |       | $                                               | 0.00       |                                          | $          | (0.01 | ) | $ | 0.04 |   | $ | (0.02 | ) |
| Average shares  outstanding:              |       |                                            |       |                                          |       |   |   |   |   |
| Basic                                     |       | 30,092                                          |       | 30,071                                        |       | 30,086 |   | 30,070 |   |
| Diluted                                   |       | 30,731                                          |       | 30,071                                        |       | 30,657 |   | 30,070 |   |

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

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**PLCSYSTEMS INC.**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS(In thousands)(Unaudited)
| ** **                                                                                  | ** ** | **Six Months Ended  June 30,** | ** ** |
|---------------------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                                  | ** ** | **2006**                                      | ** ** | **2005** | ** ** |
| Operating activities:                                                                       |       |                                          |       |   |   |
| Net income (loss)                                                                           |       | $                                             | 1,363      |   | $ | (474 | ) |
|                                                                                        |       |                                          |       |   |   |
| Adjustments to  reconcile net loss to net cash provided by (used for) operating activities: |       | 63                                            |       | 68 |   |
| Depreciation and  amortization                                                              |       |                                          |       |   |   |
| Loss on retirement of equipment                                                             |       | 77                                            |       | — |   |
| Compensation expense from stock options                                                     |       | 33                                            |       | — |   |
|                                                                                        |       |                                          |       |   |   |
| Change in assets  and liabilities:                                                          |       |                                          |       |   |   |
| Accounts receivable — Edwards                                                          |       | (535                                          | )          | 44 |   |
| Accounts receivable — other                                                            |       | 19                                            |       | 64 |   |
| Inventories                                                                                 |       | (23                                           | )          | (35 | ) |
| Prepaid expenses and other assets                                                           |       | 56                                            |       | (276 | ) |
| Accounts payable                                                                            |       | 95                                            |       | 65 |   |
| Deferred revenue — Edwards                                                             |       | (142                                          | )          | 364 |   |
| Deferred revenue — other                                                               |       | (6                                            | )          | (1 | ) |
| Accrued liabilities                                                                         |       | (152                                          | )          | 121 |   |
| Net cash  provided by (used for) operating activities                                       |       | 848                                           |       | (60 | ) |
|                                                                                        |       |                                          |       |   |   |
| Investing activities:                                                                       |       |                                          |       |   |   |
| Purchase of investments                                                                     |       | (4,000                                        | )          | (6,900 | ) |
| Maturity of investments                                                                     |       | 5,400                                         |       | — |   |
| Purchase of equipment                                                                       |       | (34                                           | )          | (30 | ) |
| Net cash  provided by (used for) investing activities                                       |       | 1,366                                         |       | (6,930 | ) |
|                                                                                        |       |                                          |       |   |   |
| Financing activities:                                                                       |       |                                          |       |   |   |
| Net proceeds from sales of common shares                                                    |       | 108                                           |       | 6 |   |
| Net cash  provided by financing activities                                                  |       | 108                                           |       | 6 |   |
|                                                                                        |       |                                          |       |   |   |
| Effect of  exchange rate changes on cash and cash equivalents                               |       | 14                                            |       | (49 | ) |
| Net increase  (decrease) in cash and cash equivalents                                       |       | 2,336                                         |       | (7,033 | ) |
|                                                                                        |       |                                          |       |   |   |
| Cash and cash  equivalents at beginning of period                                           |       | 2,560                                         |       | 9,678 |   |
| Cash and cash  equivalents at end of period                                                 |       | $                                             | 4,896      |   | $ | 2,645 |   |

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

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**PLCSYSTEMS INC.**NOTESTO CONDENSED CONSOLIDATED FINANCIAL STATEMENTSJune 30, 2006

***1.******             ******Nature of Business***

PLC Systems Inc. (“PLC” or the “Company”) is a medicaldevice company specializing in innovative technologies for the cardiac andvascular markets.  The Company currentlymanufactures two lasers that are used in the treatment of cardiovasculardisease.  PLC pioneered the *CO**2 Heart Laser System* (“The Heart LaserSystem”) that cardiac surgeons use to perform carbon dioxide (CO2) transmyocardial revascularization (“TMR”)to alleviate symptoms of severe angina. The Company’s exclusive distributor for TMR products in the UnitedStates is Edwards Lifesciences LLC (“Edwards”). In addition, the Company manufactures the Optiwave 980 laser (“Optiwave980”) under a supply agreement with Edwards. The Optiwave 980 is expected to be utilized by surgeons to ablatecardiac tissue as a means to treat certain heart arrhythmias.  As a result of these exclusive distributorand supply arrangements, Edwards is the Company’s largest customer, accountingfor 91% and 86% of the Company’s total sales in the three and six months endedJune 30, 2006, respectively. Edwards is also the Company’s largest shareholder,owning approximately 18% of its outstanding stock as of June 30, 2006.

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

The accompanying unaudited condensed consolidatedfinancial statements of the Company have been prepared in accordance withgenerally accepted accounting principles for interim financial information andwith the instructions to Form 10-Q and Article 10 of Regulation S-X.  Accordingly, they do not include all of theinformation and footnotes required by generally accepted accounting principlesfor complete financial statements.  Inthe opinion of management, all adjustments (consisting of normal recurringadjustments) considered necessary for a fair presentation have beenincluded.  Operating results for thethree and six months ended June 30, 2006 are not necessarily indicative of theresults that may be expected for the year ending December 31, 2006.  These financial statements should be read inconjunction with the consolidated financial statements and footnotes theretoincluded in the Company’s Annual Report on Form 10-K for the year endedDecember 31, 2005.

***3.******             ******Edwards Transaction***

In February 2004, the Company signed an agreement withEdwards to assume development and manufacturing of the Optiwave 980 and relatedsystem disposables. In March 2006, the Company and Edwards terminated thisagreement and entered into a new agreement. The Company received $1,500,000 inconsideration for selling its Optiwave 980 system related disposablemanufacturing and development rights to Edwards.  The Company will continue to be the exclusivemanufacturer of the current generation of Optiwave 980 laser console forEdwards and will have certain rights of first refusal related to thedevelopment and manufacture of any next generation laser.  Separately, Edwards pays the Company aroyalty on all future Optiwave 980 system related disposable sales until suchtime that cumulative royalty payments from Edwards reach $1,700,000.  For each of the three and six months endedJune 30, 2006, the Company recorded $8,000 of royalty revenue, which isincluded in the accompanying Condensed Consolidated Statements of Operations.

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In conjunction with the sale of the Optiwave 980disposable manufacturing rights, the Company wrote off certain inventory andcapital assets acquired to manufacture the Optiwave 980 disposables.  The Company recorded a gain of $1,432,000 onthe sale of its manufacturing rights in its statement of operations during thefirst quarter of 2006.  A summary of thecomponents of this gain are as follows:

| Proceeds from sale of  manufacturing rights |   | $       | 1,500,000 |   |
|---------------------------------------------|--------|---------|-----------|--------|
| Net book value  of production equipment     |   | (52,000 | )         |
| Inventory                                   |   | (16,000 | )         |
| Gain on sale of  manufacturing rights       |   | $       | 1,432,000 |   |

 

***4.******             ******Earnings (Loss) per Share***

For the three and six months ended June 30, 2006,basic earnings per share have been computed using only the weighted averagenumber of common shares outstanding during the period, while diluted earningsper share have been computed using the weighted average number of common sharesoutstanding during the period plus the effect of outstanding dilutive stock optionsusing the treasury stock method.

For the three and six months ended June 30, 2005,basic and diluted earnings per share have been computed using only the weightedaverage number of common shares outstanding during the period without givingeffect to any potential future issuances of common stock related to stockoption programs or warrants, since their inclusion would be antidilutive.

In calculating diluted earnings per share, thedilutive effect of stock options is computed using the average market price forthe respective period.  For the threemonths ended June 30, 2006 and 2005, 1,759,075 and 4,718,422 shares,respectively, and for the six months ended June 30, 2006 and 2005, 1,759,075and 4,718,422 shares, respectively, attributable to outstanding stock optionswere excluded from the calculation of diluted earnings (loss) per share becausethe effect was antidilutive.  For thethree and six months ended June 30, 2005, 1,100,000 shares attributable tooutstanding common stock warrants were also excluded from the calculation ofdiluted loss per share because the effect was antidilutive.  The following table sets forth thecomputation of basic and diluted earnings (loss) per share.

7

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|                                                                                                        | ** ** | **Three Months Ended  June 30,**                    | ** ** | **Six Months Ended  June 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                                             | ** ** | **2006**                                                           | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                                                             | ** ** | **(In thousands, except per share data)** | ** ** |
| Basic:                                                                                                 |       |                                                               |       |                                          |       |   |   |   |   |
| Net income (loss)                                                                                      |       | $                                                                  | 72         |                                          | $          | (290 | ) | $ | 1,363 |   | $ | (474 | ) |
| Weighted average  shares outstanding                                                                   |       | 30,092                                                             |       | 30,071                                        |       | 30,086 |   | 30,070 |   |
| Earnings (loss)  per share                                                                             |       | $                                                                  | .00        |                                          | $          | (0.01 | ) | $ | 0.05 |   | $ | (0.02 | ) |
| Diluted:                                                                                               |       |                                                               |       |                                          |       |   |   |   |   |
| Net income (loss)                                                                                      |       | $                                                                  | 72         |                                          | $          | (290 | ) | $ | 1,363 |   | $ | (474 | ) |
| Weighted average  shares outstanding                                                                   |       | 30,092                                                             |       | 30,071                                        |       | 30,086 |   | 30,070 |   |
| Assumed impact  of the exercise of outstanding dilutive stock options using the treasury  stock method |       | 639                                                                |       | —                                        |       | 571 |   | — |   |
| Weighted average  common and common equivalent shares                                                  |       | 30,731                                                             |       | 30,071                                        |       | 30,657 |   | 30,070 |   |
| Earnings (loss) per  share                                                                             |       | $                                                                  | 0.00       |                                          | $          | (0.01 | ) | $ | 0.04 |   | $ | (0.02 | ) |

 

***5.******             ******Stock-Based Compensation***

*StockOption and Stock Purchase Plans*

In May 2005,the Company adopted the 2005 Stock Incentive Plan (the “2005 Plan”).  The 2005 Plan has replaced the 1997 ExecutiveStock Option Plan, 2000 Equity Incentive Plan, 2000 Non-Statutory Stock OptionPlan and 2000 Non-Qualified Performance and Retention Equity Plan (the “PreviousPlans”), under which no further awards can be granted from the Previous Plansafter the adoption of the 2005 Plan.

Thenumber of Options that may be granted under the 2005 Plan is equal to 2,156,175shares of common stock (subject to adjustment in the event of stock splits andother similar events), plus such number of shares as may become available underthe Previous Plans after the date of the adoption of the 2005 Plan because anyaward previously granted under any such plan expires or is terminated,surrendered or cancelled without having been fully exercised or is forfeited inwhole or in part or results in any common stock not being issued, provided thatsuch number of additional shares may not exceed 2,535,492.  Incentive stock options are issuable only toemployees of the Company, while non-qualified options may be issued tonon-employee directors, consultants, and others, as well as to employees. Theoptions granted under the Previous Plans and the 2005 Plan become exercisableeither immediately, or ratably over one to four years from the date of grant,and expire ten years from the date of grant.

TheCompany grants stock options to its non-employee directors. Generally, newnon-employee directors receive an initial grant of an option to purchase 30,000shares of the Company’s common stock that vests in installments over threeyears.  Once the initial grant has fullyvested, non-employee directors other than the Chairman of the Board receive anannual grant of an option to purchase 15,000 shares of the Company’s commonstock that generally 

8

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vests either immediately or in four equal quarterlyinstallments. The Chairman of the Board receives an annual grant of an optionto purchase 30,000 shares of the Company’s common stock that vests eitherimmediately or in four equal quarterly installments in the same manner as theoptions granted annually to the other non-employee directors. All such optionshave an exercise price equal to the fair market value of the common stock onthe date of grant.

Theper share exercise price of the common stock subject to an incentive stockoption may not be less than the fair market value of the common stock on thedate the option is granted. The Company must grant non-qualified options at anexercise price of at least 85% of the fair market value of the common stock.

TheCompany has a 2000 Employee Stock Purchase Plan (the “Purchase Plan”) for alleligible employees.  Prior to December 1,2005, shares of the Company’s common stock could be purchased at six-monthintervals at 85% of the lower of the fair market value on the first or the lastday of each six-month period.  OnNovember 30, 2005, the Company adopted an amendment to the Purchase Planwhich provides that the purchase price for each share of the Company’s commonstock purchased under the Plan will be 95% of the closing price of the Company’scommon stock on the last business day of the relevant plan period.  The change in the purchase price waseffective beginning with the plan period commencing on December 1, 2005.Employees may purchase shares having a value not exceeding 10% of their grosscompensation during an offering period, subject to certain additionallimitations. Under the Purchase Plan, employees of the Company purchased 631shares of common stock in 2006, 12,044 shares of common stock in 2005, and13,390 shares of common stock in 2004 at average prices of $0.62, $0.51 and$0.70 per share, respectively.  At June30, 2006, 321,856 shares were reserved for future issuance under the PurchasePlan.

*Adoption of SFAS 123(R)*

EffectiveJanuary 1, 2006, the Company adopted the fair value recognition provisionsof Statement of Financial Accounting Standards No. 123(R), *Share-Based Payment*(“SFAS 123(R)”)*,* using the modified-prospectivetransition method, which did not require restatement of prior period results.Under this transition method, compensation expense totaling $23,000 and$33,000, respectively, was recognized in the accompanying statement ofoperations for the three and six months ended June 30, 2006. The compensationexpense recorded includes (a) $18,000 of compensation cost for allshare-based payments granted prior to, but not yet vested as of January 1,2006, based on the grant date fair value calculated in accordance with theoriginal provisions of Statement of Financial Accounting Standards No. 123, *Accounting for Stock-based Compensation* (“SFAS 123”), and(b) $15,000 of compensation cost for all share-based payments grantedsubsequent to December 31, 2005, based on the grant-date fair value estimatedin accordance with the provisions of SFAS 123(R). The Company estimates anexpected forfeiture rate based on its historical forfeiture activity.  Actual results, and future changes in estimates,may differ substantially from the Company’s current estimates.  As of June 30, 2006, the Company had $256,000of total unrecognized compensation cost related to its unvested options, whichis expected to be recognized over a weighted average period of nineteen months.

Theweighted average fair value of options issued during the three and six monthsended June 30, 2006 were estimated using the Black-Scholes model.

9

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|                          | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|--------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **               | ** ** | **2006**                                        | ** ** | **2006**                                      | ** ** |
| Expected life  (years)   |       | 5.50-6.00                                       |       | 5.50-6.00                                     |       |
| Interest rate            |       | 4.92-5.05                                       | %          | 4.07-5.05                                     | %          |
| Volatility               |       | 91.24-92.08                                     | %          | 91.24-93.3                                    | %          |
| Expected  dividend yield |       | None                                            |       | None                                          |       |
| Value of option          |       | $                                               | 0.48-0.50  |                                          | $          | 0.48-0.50 |   |
|                          |            |                                                 |            |                                               |            |  |  |

 

The expected lifeis calculated using the simplified method. The risk-free interest rate is basedon the U.S. Treasury yield curve in effect at the time of the grant for theexpected term period.  Expectedvolatility is based exclusively on historical volatility data of the Company’scommon stock.

*Options Outstanding*

Thefollowing table summarizes stock option activity during the six months endedJune 30, 2006:

 

|                                 | ** ** | **Number  of  Options**                                             | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted   Average  Remaining  Contractual  Term (Years)** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|---------------------------------|------------|---------------------------------------------------------------------|------------|----------------------------------------|------------|------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                      | ** ** | **(in thousands, except per option data)** | ** ** |
| Outstanding,  December 31, 2005 |       | 4,688                                                               |       | $                                      | 1.19       |                                                                   |       |                            |       |   |
| Granted                         |       | 546                                                                 |       | 0.67                                   |       |                                                                   |       |                            |       |
| Exercised                       |       | (157                                                                | )          | 0.68                                   |       |                                                                   |       |                            |       |
| Canceled                        |       | (21                                                                 | )          | 1.07                                   |       |                                                                   |       |                            |       |
| Outstanding,  June 30, 2006     |       | 5,056                                                               |       | 1.15                                   |       | 6.52                                                                   |       | $                               | 1,819      |   |
| Exercisable, June 30,  2006     |       | 4,416                                                               |       | 1.21                                   |       | 6.09                                                                   |       | 1,589                           |       |
|                                 |            |                                                                     |            |                                        |            |                                                                        |            |                                 |            |  |  |

 

Theaggregate intrinsic value amounts in the table above represent the differencebetween the closing price of the Company’s common stock on June 30, 2006 andthe exercise price, multiplied by the in-the-money stock options as of the samedate.  The total intrinsic value ofoptions exercised during the three months ended June 30, 2006 was $39,000.

Optionsgranted during 2006 will vest ratably annually over a three year period foremployees and ratably quarterly over a one year period for non-employeedirectors. Options granted during 2005 to both employees and non-employeedirectors vested immediately upon granting.

The followingtable summarizes unvested share activity during the six months ended June 30,2006:

10

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|                               | ** ** | **Number  of  Options**                                                   | ** ** | **Weighted   Average  Grant Date  Fair Value** | ** ** |
|-------------------------------|------------|---------------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                    | ** ** | **(in thousands, except weighted average data)** | ** ** |
| Nonvested,  December 31, 2005 |       | 101                                                                       |       | $                                                             | 0.37       |   |
| Granted                       |       | 546                                                                       |       | 0.66                                                          |       |
| Vested                        |       | —                                                                    |       | —                                                        |       |
| Canceled                      |       | (7                                                                        | )          | 0.74                                                          |       |
| Nonvested, June 30,  2006     |       | 640                                                                       |       | $                                                             | 0.68       |   |

 

*Pro FormaInformation for Period Prior to SFAS 123(R) Adoption*

The Company hashistorically granted stock options for a fixed number of shares to employeesand certain other individuals with exercise prices equal to the fair value ofthe shares at the dates of grant. Through December 31, 2005 the Company adoptedthe disclosure only provisions of SFAS 123, and accounted for its stock optionplans in accordance with the provisions of Accounting Principles Board Opinion25, *Accounting for Stock Issued to Employees*(“APBOpinion No. 25”).  Under APB Opinion No.25, compensation expense with respect to such awards is not recognized if onthe date the awards were granted the exercise price was equal to or greaterthan the fair market value of the underlying common shares.

Thefollowing table illustrates the effect on net loss and basic loss per share ifthe Company had applied the fair value recognition provisions of SFAS 123 tostock-based employee compensation during the three and six month periods endedJune 30, 2005.  For purposes of this proforma disclosure, the value of the options is estimated using the Black-Scholesoption-pricing model and is being amortized to expense over the options’vesting periods.

|                                                                                                                      | ** ** | **Three Months  Ended  June 30, 2005**              | ** ** | **Six Months  Ended  June 30, 2005** | ** ** |
|----------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                                           | ** ** | **(In thousands, except per share data)** | ** ** |
| Net loss  attributable to common stockholders— As reported                                                      |       | $                                                                  | (290       | )                                                   | $          | (474 | ) |
| Deduct total  stock-based compensation expense determined under fair value based method for  all stock option awards |       | (132                                                               | )          | (166                                                | )          |
| Net loss  attributable to common stockholders—Pro forma                                                         |       | $                                                                  | (422       | )                                                   | $          | (640 | ) |
| Loss per basic  and diluted share attributable to common stockholders— As reported                              |       | $                                                                  | (0.01      | )                                                   | $          | (0.02 | ) |
| Loss per basic and  diluted share attributable to common stockholders— Pro forma                                |       | $                                                                  | (0.01      | )                                                   | $          | (0.02 | ) |

 

11

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The fair value of issued optionsat the date of grant was estimated using the Black-Scholes model with thefollowing weighted average assumptions:

|                         | ** ** | **Three Months Ended  June 30, 2005** | ** ** |
|-------------------------|------------|-----------------------------------------------------------|------------|
| Expected life  (years)  |       | 3                                                         |       |
| Interest rate           |       | 3.68                                                      | %          |
| Volatility              |       | 40.1                                                      | %          |
| Expected dividend yield |       | None                                                      |       |

 

***6.******             ******Comprehensive Income (Loss)***

Totalcomprehensive income for the three and six month periods ended June 30, 2006amounted to $80,000 and $1,374,000, respectively, as compared to acomprehensive loss of $307,000 and $505,000, respectively, for the three andsix month periods ended June 30, 2005. Comprehensive income (loss) is comprised of net income (loss) plus theincrease/decrease in currency translation adjustment.

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

Inventories are stated at the lower of cost (computed on afirst-in, first-out method) or market value and include allocations of laborand overhead.  As of June 30, 2006 andDecember 31, 2005, inventories consisted of the following (in thousands):

|                  | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|------------------|------------|-------------------------|------------|-----------------------------|------------|
| Raw materials    |       | $                       | 814        |                        | $          | 701 |   |
| Work in progress |       | 56                      |       | 67                          |       |
| Finished goods   |       | 116                     |       | 195                         |       |
|             |       | $                       | 986        |                        | $          | 963 |   |

 

At June 30, 2006 and December 31, 2005, inventories arestated net of a reserve of $473,000 and $533,000, respectively, for potentiallyexcess and obsolete inventory.

***8.******             ******Revenue Recognition***

The Company records revenue from the sale of TMR kitsand the Optiwave 980 at the time of shipment to Edwards.  TMR kit revenues include the amount invoicedto Edwards for kits shipped pursuant to purchase orders received, as well as anamortized portion of deferred revenue related to a payment of $4,533,333received from Edwards in February 2004. This payment was made by Edwards in exchange for a reduction in theprospective purchase price the Company receives from Edwards upon a sale of thekits.  The Company is amortizing thispayment from Edwards into its Consolidated Statement of Operations as revenueover a seven year period (culminating in 2010) under the units-of-revenuemethod as prescribed by Emerging Issues Task Force (EITF) 88-18, *Sales of Future Revenue*. Management determined that a seven year timeframe was the most appropriateamortization period based on a valuation model they used to assess the economicfairness of the payment. Factors management considered in 

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developing this valuation model included the estimatedforegone revenues over a seven year period resulting from the reduction in theprospective purchase price payable to the Company by Edwards, a discount ratedeemed appropriate to this transaction and an estimate of the remainingeconomic useful life of the current TMR kit design, without any benefit beinggiven to potential future product improvements the Company may make.  Management reviews annually, and adjusts ifnecessary, the prospective revenue amortization rate for kits based on its bestestimate of the total number of kits likely remaining to be shipped to hospitalcustomers by Edwards through 2010.  Basedon this, for the three and six months ended June 30, 2006 the Company recordedamortization of $170,000 and $325,000, respectively, as compared to $98,000 and$174,000, respectively, for the three and six months ended June 30, 2005.  These amounts are included in revenues in theConsolidated Statements of Operations for the respective periods.

TMR lasers are billed to Edwards in accordance withpurchase orders that the Company receives. Invoiced TMR lasers are recorded as other current assets and deferredrevenue on the Company’s Consolidated Balance Sheet until such time as thelaser is shipped to a hospital, at which time the Company records revenue andcost of revenue.

Under the terms of the Edwards TMR distributionagreement, once Edwards has recovered a prescribed amount of revenue from ahospital for the use or purchase of a TMR laser, any additional revenues earnedby Edwards are shared with the Company pursuant to a formula established in thedistribution agreement. The Company only records its share of such additionalrevenue, if any, at the time the revenue is earned.

The Company records revenue from the sale of TMR kitsand TMR lasers to international distributors or hospitals at the time of shipment.

Revenues from service and maintenance contracts arerecognized ratably over the life of the contract.

Installation revenues related to a TMR lasertransaction are recorded as a component of service fees when the laser isinstalled.

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

The Company warranties its products againstmanufacturing defects under normal use and service during the warrantyperiod.  The Company obtains similarwarranties from a majority of its suppliers, including those who supply criticalHeart Laser System components.  Inaddition, under the terms of its TMR distribution agreement with Edwards, theCompany is able to bill Edwards for actual warranty costs, includingpreventative maintenance services, up to a specified amount during the warrantyperiod.

The Company evaluates the estimated futureunrecoverable costs of warranty and preventative maintenance services for itsinstalled base of lasers on a quarterly basis and adjusts its warranty reserveaccordingly.  The Company considers allavailable evidence, including historical experience and information obtainedfrom supplier audits.

13

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

|                                                            | ** ** | **Six Months Ended  June 30,** | ** ** |
|------------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                 | ** ** | **2006**                                      | ** ** | **2005** | ** ** |
| Balance,  beginning of period                              |       | $                                             | 60         |   | $ | 60 |   |
| Payments made                                              |       | —                                        |       | — |   |
| Change in  liability for warranties issued during the year |       | —                                        |       | — |   |
| Change in  liability for preexisting warranties            |       | —                                        |       | — |   |
| Balance, end of period                                     |       | $                                             | 60         |   | $ | 60 |   |

 

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

This quarterly report (including certain information incorporatedherein by reference) contains forward-looking statements within the meaning ofSection 27A of the Securities Act of 1933, as amended, and Section 21E of theSecurities Exchange Act of 1934, as amended (the “Exchange Act”). Statementscontaining terms such as “believes”, “plans”, “expects”, “anticipates”, “intends”,“estimates” and similar expressions reflect uncertainty and are forward-lookingstatements. Forward-looking statements are based on current plans andexpectations and involve known and unknown important risks and uncertaintiesthat could cause actual results to differ materially from those described inthe forward-looking statements. Such important factors and uncertaintiesinclude, but are not limited to, those set forth below in Part II, Item 1A.Risk Factors, and elsewhere in this quarterly report.

# **Overview**

Weare a medical device company specializing in innovative technologies for thecardiac and vascular markets.  Wecurrently manufacture two lasers that are used in the treatment ofcardiovascular disease.  Our Heart LaserSystems are used to treat patients with severe angina and the Optiwave 980 isused to ablate cardiac tissue as a means to treat certain heart arrhythmias.

Edwards is our exclusive distributor for TMR productsin the United States and our largest customer, accounting for approximately 91%and 86%, respectively, of our total sales in the three and six months endedJune 30, 2006 and 89% in the year ended December 31, 2005.  We expect this sales trend to continue for thenear future.

Approximately 95% and 96%, respectively, of ourrevenues in the three and six months ended June 30, 2006 and 89% in the yearended December 31, 2005 came from the sale and service of TMR lasers andrelated disposable kits. Although not a direct measure, we believe a leadingindicator of the adoption rate of TMR as a treatment for severe angina is TMRkit shipments to U.S. hospitals. TMR kit shipments to U.S. hospitals throughEdwards decreased approximately 5% and increased approximately 2%,respectively, in the three and six months ended June 30, 2006 compared to thethree and six months ended June 30, 2005. We remain largely dependent on thesuccess of Edwards’ sales and marketing efforts to increase our installed baseof TMR lasers and increase TMR procedure volumes and revenues.

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Ourmanagement reviews a number of key performance indicators to assist them indetermining how to allocate resources and run our day to day operations. Theseindicators include (1) actual prior quarterly sales trends, (2) projected TMRlaser and kit sales for the next four quarters, as provided by Edwards in arolling twelve month sales forecast, (3) research and development progress asmeasured against internal project plan objectives, (4) budget to actual financialexpenditure results, (5) inventory levels (both our own and Edwards’) and (6)short term and long term projected cash flows of the business.

# **CriticalAccounting Policies and Estimates**

Our financial statements are based on the application of significantaccounting policies, many of which require us to make significant estimates andassumptions (see Note 2 to the Consolidated Financial Statements).  We believe that the following are some of themore material judgment areas in the application of our accounting policies thatcurrently affect our financial condition and results of operations.

# ***Inventories***

Inventoriesare stated at the lower of cost (computed on a first-in, first-out method) ormarket value and include allocations of labor and overhead.  A specific obsolescence allowance is providedfor slow moving, excess and obsolete inventory based on our best estimate ofthe net realizable value of inventory on hand taking into consideration factorssuch as (1) actual trailing twelve month sales, (2) expected future productline demand, based in part on sales forecast input received from Edwards, and(3) service part stocking levels which, in management’s best judgment, areadvisable to maintain in order to meet warranty, service contract and time andmaterial spare part demands. Historically, we have found our reserves to be adequate.

# ***Allowance for Doubtful Accounts***

For our accounts receivable, we continuously monitorcollections from customers, our principal customer being Edwards, and wemaintain a provision for estimated credit losses based upon historicalexperience and any specific customer collection issues that we haveidentified.  Historically, we have notexperienced significant losses related to our accounts receivable.  Collateral is not generally required. If thefinancial condition of our customers were to deteriorate, resulting in animpairment of their ability to make payments, additional allowances may berequired.

# ***Warranty and PreventativeMaintenance Costs***

We warranty our products against manufacturing defectsunder normal use and service during the warranty period.  We obtain similar warranties from a majorityof our suppliers, including those who supply critical Heart Laser System andOptiwave 980 components.  In addition,under the terms of our TMR distribution agreement with Edwards, we are able tobill Edwards for actual warranty costs, including preventative maintenanceservices, up to a specified amount during the warranty period.

We evaluate the estimated future unrecoverable costsof warranty and preventative maintenance services for our installed base oflasers on a quarterly basis and adjust our warranty reserve accordingly.  We consider all available evidence, includinghistorical experience and information obtained from supplier audits.

15

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# ***Revenue Recognition***

Werecord revenue from the sale of TMR kits and the Optiwave 980 at the time ofshipment to Edwards.  TMR kit revenuesinclude the amount invoiced to Edwards for kits shipped pursuant to purchaseorders received, as well as an amortized portion of deferred revenue related toEdwards’ payment to us of $4,533,333 in February 2004. This payment was made byEdwards in exchange for a reduction in the prospective purchase price wereceive from Edwards upon a sale of the kits. We are amortizing this paymentfrom Edwards into our Consolidated Statement of Operations as revenue over aseven year period (culminating in 2010) under the units-of-revenue method asprescribed by Emerging Issues Task Force (EITF) 88-18, *Sales ofFuture Revenue*. We determined that a seven year timeframe was themost appropriate amortization period based on a valuation model we used toassess the economic fairness of the payment. Factors we considered indeveloping this valuation model included the estimated foregone revenues over aseven year period resulting from the reduction in the prospective purchaseprice payable to us by Edwards, a discount rate deemed appropriate to thistransaction and an estimate of the remaining economic useful life of thecurrent TMR kit design, without any benefit being given to potential futureproduct improvements we may make. Management reviews annually, and adjusts if necessary, the prospectiverevenue amortization rate for kits based on its best estimate of the totalnumber of kits likely remaining to be shipped to hospital customers by Edwardsthrough 2010.  Based on this, for thethree and six months ended June 30, 2006, we recorded amortization of $170,000and $325,000, respectively, as compared to $98,000 and $174,000, respectively,for the three and six months ended June 30, 2005. These amounts are included inrevenues in our Consolidated Statements of Operations for the respectiveperiods.

TMR lasers are billed to Edwards in accordance withpurchase orders that we receive.  InvoicedTMR lasers are recorded as other current assets and deferred revenue on ourConsolidated Balance Sheet until such time as the laser is shipped to ahospital, at which time we record revenue and cost of revenue.

Under the terms of the Edwards TMR distributionagreement, once Edwards has recovered a prescribed amount of revenue from ahospital for the use or purchase of a TMR laser, any additional revenues earnedby Edwards are shared with us pursuant to a formula established in thedistribution agreement. We only record our share of such additional revenue, ifany, at the time the revenue is earned.

We record revenue from thesale of TMR kits and TMR lasers to international distributors or hospitals atthe time of shipment.

Revenues from service and maintenancecontracts are recognized ratably over the life of the contract.

Installation revenues related to a TMR lasertransaction are recorded as a component of service fees when the laser isinstalled.

16

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**Stock Based Compensation**

EffectiveJanuary 1, 2006, we adopted the fair value recognition provisions of SFAS123(R) using the modified-prospective transition method, which did not requirerestatement of prior period results. Under this transition method, compensationexpense totaling $23,000 and $33,000, respectively, was recognized in ourstatement of operations for the three and six months ended June 30, 2006. Thecompensation expense recorded includes (a) $18,000 of compensation cost for allshare-based payments granted prior to, but not yet vested as of January 1,2006, based on the grant date fair value calculated in accordance with theoriginal provisions SFAS 123, and (b) $15,000 of compensation cost for allshare-based payments granted subsequent to December 31, 2005, based on thegrant-date fair value estimated in accordance with the provisions of SFAS123(R). As of June 30, 2006, we had $256,000 of total unrecognized compensationcost related to our unvested options, which is expected to be recognized over aweighted average period of nineteen months.

Thevaluation of employee stock options is an inherently subjective process, sincemarket values are generally not available for long-term, non-transferableemployee stock options. Accordingly, an option pricing model is utilized toderive an estimated fair value. In calculating the estimated fair value of ourstock options, we used the Black-Scholes pricing model which requires theconsideration of six variables for purposes of estimating fair value whichinclude the stock option exercise price, the grant date price of our commonstock, the expected life of the option, the risk free interest rate for theexpected option life, the expected volatility of our common stock and****the expected dividends on our commonstock.  The expected life is calculatedusing the simplified method.  Therisk-free interest rate is based on the U.S. Treasury yield curve in effect atthe time of the grant for the expected term period.  Expected volatility is based exclusively onhistorical volatility data on our common stock. The dividend yield percentageis zero because we do not currently pay dividends nor intend to do so duringthe expected option life.

## **Results of Operations**

Results for the three andsix months ended June 30, 2006 and 2005 and the related percent of revenues wereas follows:
| ** **                             | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|----------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                             | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                             | ** ** | **$**                                           | ** ** | **%**                                         | ** ** | **$** | ** ** | **%** | ** ** | **$** | ** ** | **%** | ** ** | **$** | ** ** | **%** | ** ** |
| ** **                             | ** ** | **(dollars in thousands)**            | ** ** |
| Total revenues                         |       | 1,943                                           |       | 100                                           |       | 1,982 |   | 100 |   | 3,832 |   | 100 |   | 3,925 |   | 100 |   |
| Total cost of  revenues                |       | 722                                             |       | 37                                            |       | 790 |   | 40 |   | 1,413 |   | 37 |   | 1,518 |   | 39 |   |
| Gross profit                           |       | 1,221                                           |       | 63                                            |       | 1,192 |   | 60 |   | 2,419 |   | 63 |   | 2,407 |   | 61 |   |
| Selling, general  & administrative |       | 804                                             |       | 41                                            |       | 897 |   | 45 |   | 1,684 |   | 44 |   | 1,777 |   | 45 |   |
| Research &  development            |       | 458                                             |       | 24                                            |       | 649 |   | 33 |   | 991 |   | 26 |   | 1,220 |   | 31 |   |
| Total operating  expenses              |       | 1,262                                           |       | 65                                            |       | 1,546 |   | 78 |   | 2,675 |   | 70 |   | 2,997 |   | 76 |   |
| Gain on sale of  manufacturing assets  |       | —                                          |       | —                                        |       | — |   | — |   | 1,432 |   | 37 |   | — |   | — |   |
| Income (loss)  from operations         |       | (41                                             | )          | (2                                            | )          | (354 | ) | (18 | ) | 1,176 |   | 31 |   | (590 | ) | (15 | ) |
| Other income                           |       | 113                                             |       | 6                                             |       | 64 |   | 3 |   | 187 |   | 5 |   | 116 |   | 3 |   |
| Net income (loss)                      |       | 72                                              |       | 4                                             |       | (290 | ) | (15 | ) | 1,363 |   | 36 |   | (474 | ) | (12 | ) |

 

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** **

 
| ** **                                      | ** ** | **Three Months Ended  June 30,** | ** ** | ** ** | ** ** | ** **                                   | ** ** | **Six Months Ended  June 30,** | ** ** | ** ** | ** ** | ** **                                   | ** ** |
|-------------------------------------------------|------------|-------------------------------------------------|------------|------------|------------|----------------------------------------------|------------|-----------------------------------------------|------------|------------|------------|----------------------------------------------|------------|
| ** **                                      | ** ** | **2006**                                        | ** ** | **2005**   | ** ** | **Increase (decrease)  over 2005** | ** ** | **2006**                                      | ** ** | **2005**   | ** ** | **Increase (decrease)  over 2005** | ** ** |
| ** **                                      | ** ** | **$**                                           | ** ** | **$**      | ** ** | **$**                                        | ** ** | **%**                                         | ** ** | **$**      | ** ** | **$**                                        | ** ** | **$** | ** ** | **%** | ** ** |
| ** **                                      | ** ** | **(dollars in thousands)**            | ** ** |
|                                            |       |                                            |       |       |       |                                         |       |                                          |       |       |       |                                         |       |   |   |   |   |
| Product sales                                   |       | 1,577                                           |       | 1,567      |       | 10                                           |       | 1                                             |       | 3,057      |       | 3,125                                        |       | (68 | ) | (2 | ) |
| Service fees                                    |       | 366                                             |       | 415        |       | (49                                          | )          | (12                                           | )          | 775        |       | 800                                          |       | (25 | ) | (3 | ) |
| Total revenues                                  |       | 1,943                                           |       | 1,982      |       | (39                                          | )          | (2                                            | )          | 3,832      |       | 3,925                                        |       | (93 | ) | (2 | ) |
| Product cost of  sales                          |       | 554                                             |       | 600        |       | (46                                          | )          | (8                                            | )          | 1,065      |       | 1,152                                        |       | (87 | ) | (8 | ) |
| Service fees  cost of sales                     |       | 168                                             |       | 190        |       | (22                                          | )          | (12                                           | )          | 348        |       | 366                                          |       | (18 | ) | (5 | ) |
| Total cost of  revenues                         |       | 722                                             |       | 790        |       | (68                                          | )          | (9                                            | )          | 1,413      |       | 1,518                                        |       | (105 | ) | (7 | ) |
| Gross profit                                    |       | 1,221                                           |       | 1,192      |       | 29                                           |       | 2                                             |       | 2,419      |       | 2,407                                        |       | 12 |   | - |   |
| Selling, general  & administrative expenses |       | 804                                             |       | 897        |       | (93                                          | )          | (10                                           | )          | 1,684      |       | 1,777                                        |       | (93 | ) | (5 | ) |
| Research &  development expenses            |       | 458                                             |       | 649        |       | (191                                         | )          | (29                                           | )          | 991        |       | 1,220                                        |       | (229 | ) | (19 | ) |
| Total operating  expenses                       |       | 1,262                                           |       | 1,546      |       | (284                                         | )          | (18                                           | )          | 2,675      |       | 2,997                                        |       | (322 | ) | (11 | ) |
| Gain on sale of  manufacturing assets           |       | —                                          |       | —     |       | —                                       |       | —                                        |       | 1,432      |       | —                                       |       | 1,432 |   | 100 |   |
| Income (loss)  from operations                  |       | (41                                             | )          | (354       | )          | 313                                          |       | 88                                            |       | 1,176      |       | (590                                         | )          | 1,766 |   | 299 |   |
| Other income                                    |       | 113                                             |       | 64         |       | 49                                           |       | 77                                            |       | 187        |       | 116                                          |       | 71 |   | 61 |   |
| Net income (loss)                               |       | 72                                              |       | (290       | )          | 362                                          |       | 125                                           |       | 1,363      |       | (474                                         | )          | 1,837 |   | 388 |   |

 

***Product Sales***

TMRlaser revenues, the largest component of product sales in the three monthsended June 30, 2006, increased by $61,000, or 9%, as compared to the threemonths ended June 30, 2005. International TMR laser revenues increased $53,000,from $5,000 to $58,000, due to the sale of a single laser to an internationalcustomer in the three months ended June 30, 2006. Domestic TMR laser revenuesincreased $8,000, or 1%, as a result of an increase in the number of new TMRlasers sold by Edwards, offset by decreased revenue sharing earned under theTMR distribution agreement with Edwards.

Inthe six months ended June 30, 2006, TMR laser revenues increased by $136,000,or 10%, as compared to the six months ended June 30, 2005.  International TMR laser revenues increased$258,000, from $20,000 to $278,000, due to the sale of two lasers tointernational customers in the six months ended June 30, 2006.  Domestic TMR laser revenues decreased$122,000, or 9%, as a result of decreased revenue sharing earned under the TMRdistribution agreement with Edwards.

DisposableTMR kit revenues, the second largest component of product sales, increased by$164,000, or 29%, in the three months ended June 30, 2006 as compared to thethree months ended June 30, 2005. Domestic TMR kit revenues increased $158,000,or 28%, as a result of (1) a higher volume of kit shipments to Edwards and (2)a $72,000 increase in deferred revenue amortization related to the $4,533,333payment by Edwards in 2004. International disposable TMR kit revenues increased$6,000, or 46%, as a result of a higher volume of kit shipments tointernational customers.

18

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Inthe six months ended June 30, 2006, disposable TMR kit revenues increased by$194,000, or 16%, as compared to the six months ended June 30, 2005. DomesticTMR kit revenues increased $239,000, or 22% as a result of (1) a $151,000increase in deferred revenue amortization related to the $4,533,333 payment byEdwards and (2) an 8% higher volume of kit shipments to Edwards. Internationaldisposable TMR kit revenues decreased $45,000, or 49%, as a result of a lowervolume of kit shipments to international customers.

Optiwave980 revenues to Edwards decreased $192,000, or 100%, and $345,000, or 100%,respectively in the three and six months ended June 30, 2006 as compared to thethree and six months ended June 30, 2005, as no Optiwave 980 units were sold toEdwards in the first or second quarters of 2006.  Under our new supply agreement withEdwards that we entered into in March 2006, Edwards has agreed to purchaseany additional units of the current generation of Optiwave 980 exclusively fromus.  We believe that our future revenuesfrom sales of this current generation laser will not exceed $1,000,000 and maybe less, depending in part on demand for that product and when, if ever,Edwards chooses to introduce its next generation laser to the market.  We have a right of first refusal to developand manufacture any next generation laser for Edwards; however, at this time wehave not had discussions with Edwards regarding any such successor product.

Otherproduct sales, relating to sales of new and refurbished general purposesurgical laser tubes, decreased $23,000, or 21%, and 53,000, or 26%,respectively, in the three and six months ended June 30, 2006 as compared tothe three and six months ended June 30, 2005.

***Service Fee Revenues***

Service fee revenues decreased $49,000, or 12%, in thethree months ended June 30, 2006 as compared to the three months ended June 30,2005.  Domestic service fees decreased$27,000, or 8%, due to decreased billings to Edwards for service related calls,offset in part by increased revenues generated from service contracts.International service fees decreased $22,000, or 40%, due to a decrease inbillings to a single international customer whose HL2 laser was removed.

Service fee revenues decreased $25,000, or 3%, in thesix months ended June 30, 2006 as compared to the six months ended June 30,2005.  Domestic service fees increased$25,000, or 4%, due to increased revenues generated from service contracts,offset in part by decreased billings to Edwards for service related calls.International service fees decreased $50,000, or 39%, due to a decrease inbillings to a single international customer whose HL2 laser was removed.

***Gross Profit***

Totalgross profit was $1,221,000, or 63% of total revenues, for the three monthsended June 30, 2006 as compared with gross profit of $1,192,000, or 60% oftotal revenues, for the three months ended June 30, 2005.  The increase in gross profit dollars is dueto (1) higher disposable TMR kit revenues, (2) an increase in the number of newdomestic TMR lasers sold and (3) higher international TMR laser sales.  These increases were offset in part by (1) adecrease in additional revenue sharing on lasers earned under the TMRdistribution agreement with Edwards and (2) a decrease in Optiwave 980revenues.

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Totalgross profit was $2,419,000, or 63% of total revenues, for the six months endedJune 30, 2006 as compared with gross profit of $2,407,000, or 61% of totalrevenues, for the six months ended June 30, 2005.  The increase in gross profit dollars is dueto (1) higher disposable TMR kit revenues and (2) higher international TMRlaser sales.  These increases were offsetin part by (1) a decrease in Optiwave 980 revenues and (2) a decrease inadditional revenue sharing earned under the TMR distribution agreement withEdwards.

***Selling, General and AdministrativeExpenses***

Selling,general and administrative expenses decreased 10% and 5%, respectively, in thethree and six months ended June 30, 2006 as compared to the three and sixmonths ended June 30, 2005.  Thedecreases for both 2006 periods are a result of lower legal expenses as well aslower incentive compensation.

***Research and Development Expenses***

Researchand development expenditures decreased 29% and 19%, respectively, in the threeand six months ended June 30, 2006 as compared to the three and six monthsended June 30, 2005.  There was adecrease in expenditures in connection with the Optiwave 980 and our newproduct development.

Weexpect to continue to incur significant new research and developmentexpenditures in 2006 and future years in pursuit of our business strategy tobroaden and diversify our product portfolio beyond our current TMR offerings.

***Gain on Sale of Manufacturing Rights***

InMarch 2006, we received $1,500,000 related to the sale of our Optiwave 980System disposable manufacturing and development rights to Edwards (See Note 3to the consolidated financial statements). In conjunction with thistransaction, we wrote off certain inventory and capital assets acquired tomanufacture the Optiwave 980 disposables, and we recorded a gain of $1,432,000on the sale of our manufacturing rights in our statement of operations duringthe first quarter of 2006.  A summary ofthe components of this gain are outlined below:

| Proceeds from sale of  manufacturing rights |   | $       | 1,500,000 |   |
|---------------------------------------------|--------|---------|-----------|--------|
| Net book value  of production equipment     |   | (52,000 | )         |
| Inventory                                   |   | (16,000 | )         |
| Gain on sale of  manufacturing rights       |   | $       | 1,432,000 |   |

 

***Other Income***

Thelargest component of other income is interest income earned on our cash, cashequivalents and short-term investments. Interest income increased $49,000, or77%, and $71,000, or 61%, respectively, in the three and six months ended June30, 2006 as compared to the three and six months ended June 30, 2005 due tohigher interest rates earned on our cash, cash equivalents and short-terminvestments and higher investable balances.

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***Net Income (Loss)***

In the three months endedJune 30, 2006, we recorded net income of $72,000 as compared to a net loss of$290,000 in the three months ended June 30, 2005.  This increase is primarily a result of loweroperating expenses and higher other income in the three months ended June 30,2006 as compared to the three months ended June 30, 2005.

In the first quarter, werecorded a gain of $1,432,000 from the sale of our Optiwave 980 disposablemanufacturing rights to Edwards.  Thisnon-recurring gain resulted in our recording net income for the six monthsended June 30, 2006 of $1,363,000, as compared to a net loss of $474,000 forthe six months ended June 30, 2005.

***Kit Shipments***

We view disposable kit shipments to end users as animportant metric in evaluating our business.  We believe that kit shipments (particularlykit shipments to U.S. hospitals), although not a direct measure, are areasonable indicator for the adoption of TMR as a therapy in the marketplace.  Disposable kit shipments to end users are asfollows:
| ** **    | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|---------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **    | ** ** | **2006**                                            | ** ** | **2005**                                          | ** ** | **% Increase  over 2005** | ** ** | **2006** | ** ** | **2005** | ** ** | **% Increase  over 2005** | ** ** |
|          |       |                                                |       |                                              |       |   |   |   |   |   |   |   |   |
| Domestic      |       | 537                                                 |       | 566                                               |       | (5 | ) | 1,028 |   | 1,005 |   | 2 |   |
| International |       | 10                                                  |       | 5                                                 |       | 100 |   | 25 |   | 55 |   | (55 | ) |
| Total         |       | 547                                                 |       | 571                                               |       | (4 | ) | 1,053 |   | 1,060 |   | (1 | ) |

 

Webelieve the overall limited growth in TMR kit shipments in recent years may bepartly attributable to what we believe may be an ongoing downward trend in thenumber of heart bypass surgeries being performed. We believe the proliferationin the number of interventional cardiac procedures being performed,particularly with the recent advent of drug eluting stents, is causing a delayin the number of patients being referred to cardiac surgeons for treatment oftheir cardiovascular disease. Because a significant number of the total TMRprocedures performed each year by cardiac surgeons are done in combination withbypass surgery, we believe the growth in the number of TMR procedures may bebeing adversely impacted by this reduction in the number of bypass surgeriesbeing performed.

**Liquidityand Capital Resources**

Cash,cash equivalents and short-term investments totaled $10,396,000 as of June 30,2006, an increase of $936,000 from $9,460,000 as of December 31, 2005.  Our short-term investments consist of moniesinvested in bank certificates of deposit. We have no debt obligations. We believe that our existing cash resourceswill meet our working capital requirements through at least the next 12 months.

Cashprovided by operating activities in the six months ended June 30, 2006 was$848,000 due to our net income (including from the sale of the Optiwave 980manufacturing rights) and non-cash depreciation, amortization, loss onretirement of equipment and 

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compensation expense related to stock options,partially offset by overall unfavorable working capital changes. Additionalcash was provided by net proceeds from the sales of common shares of $108,000and the effect of foreign exchange rate changes totaling $14,000.  We used $34,000 for the purchase ofequipment.

Weare largely dependent on the success of Edwards’ sales and marketing efforts inthe U.S. to continue to increase the installed base of HL2 and Optiwave 980lasers and to substantially increase TMR procedural volumes and revenues.Should the installed 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 orchanges or delays in third-party reimbursement to healthcare providers usingour products may adversely impact our cash position and require further costreductions or the need to obtain additional financing.  It is not certain that we, working withEdwards and our international distributors, will be successful in achievingbroad commercial acceptance of either the Heart Laser Systems or the Optiwave980, 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 HeartLaser Systems on a usage basis rather than as a capital equipmentpurchase.  We believe this is the resultof limitations many hospitals currently have on acquiring expensive capital equipmentas well as competitive pressures in the marketplace.  A usage business model will result in alonger recovery period for Edwards to recoup its investment in lasers itpurchases from us.  This results in (1) adelay in our ability to receive additional shared revenue, if any, that we otherwiseare entitled to receive under the terms of our distribution agreement withEdwards (see “Critical Accounting Policies and Estimates — Revenue Recognition”)and (2) a delay in the purchase of new lasers by Edwards if its installed baseof lasers placed under usage contracts are under-performing and it chooses tore-deploy these lasers to other hospital sites in lieu of purchasing a newlaser from us.  Our cash position and ourneed for additional financing to fund operations will be dependent in part uponthe number of hospitals that acquire Heart Laser Systems from Edwards on ausage basis and the number and frequency of TMR procedures performed by thesehospitals.

Furthermore, we have undertaken a new businessstrategy that involves broadening and diversifying our product portfolio beyondour current TMR offerings, by developing or acquiring new and innovativemedical devices to address cardiac and vascular related markets. We believethis strategy will result in our incurring losses for at least the next 18-30months as we increase our research and development spending.  We cannot be certain that we will besuccessful in implementing our business strategy or that future sales, if any,from these planned new products will recover the investments we plan to make.If we are unsuccessful in implementing our business strategy, or if thediversification of our product portfolio takes longer or costs more thananticipated, our liquidity and capital resources will be adversely affected andwe may need to obtain additional financing.

Therecan be no assurance that, should we require additional financing, suchfinancing will be available on terms and conditions acceptable to us, if atall.  Should additional financing not beavailable on terms and conditions acceptable to us, additional actions may berequired that could adversely impact our ability to continue to realize assetsand satisfy liabilities in the normal course of business.  The consolidated financial statements setforth in this report do not include any adjustments to reflect the possiblefuture effects of these uncertainties.

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**Off-BalanceSheet Arrangements**

None.

**Item 3.        Quantitativeand Qualitative Disclosures about Market Risk**

A portion of our operations consists of sales activities in foreignjurisdictions.  We manufacture ourproducts exclusively in the U.S. and sell our products in the U.S. and abroad.As a result, our financial results could be affected by factors such as changesin foreign currency exchange rates or weak economic conditions in the foreignmarkets in which we distribute our products. Our operating results are exposed to changes in exchange rates betweenthe U.S. dollar and foreign currencies, especially the Euro. When the U.S.dollar strengthens against the Euro, the value of foreign sales decreases. Whenthe U.S. dollar weakens, the value of foreign sales increases. No assurance canbe given that foreign currency fluctuations in the future will not adverselyaffect our business, financial condition and results of operations, although atpresent we do not believe that our exposure is significant, as internationalsales represented only 6% and 11%, respectively, of our consolidated sales inthe three and six months ended June 30, 2006 and 6% in the year ended December31, 2005. We do not hedge any balance sheet exposures and intercompany balancesagainst future movements in foreign exchange rates.

Ourinterest income and expense are sensitive to changes in the general level ofU.S. and foreign interest rates. In this regard, changes in U.S. and foreigninterest rates affect the interest earned on our cash and cashequivalents.  We do not believe that a10% change to the applicable interest rates would have a material impact on ourfuture results of operations or cash flows.

## **Item 4.        Controls andProcedures**

Our management, with theparticipation of our chief executive officer and chief financial officer,evaluated the effectiveness of our disclosure controls and procedures as ofJune 30, 2006.  The term “disclosurecontrols and procedures”, as defined in Rules 13a-15(e) and 15d-15(e) under theExchange Act, means controls and other procedures of a company that aredesigned to ensure that information required to be disclosed by a company inthe reports that it files or submits under the Exchange Act is recorded,processed, summarized and reported within the time periods specified in the SEC’srules and forms.  Disclosure controls andprocedures include, without limitation, controls and procedures designed toensure that information required to be disclosed by a company in the reportsthat it files or submits under the Exchange Act is accumulated and communicatedto the company’s management, including its principal executive and principalfinancial officers, as appropriate to allow timely decisions regarding requireddisclosure.  Management recognizes thatany controls and procedures, no matter how well designed and operated, canprovide only reasonable assurance of achieving their objectives and managementnecessarily applies its judgment in evaluating the cost-benefit relationship ofpossible controls and procedures.  Basedon the evaluation of our disclosure controls and procedures as of June 30,2006, our chief executive officer and chief financial officer concluded that,as of such date, our disclosure controls and procedures were effective at thereasonable assurance level.

No change in our internal control over financial reporting (as definedin Rules 13a-15(f) and 15d-15(f) under the Exchange Act) occurred during thefiscal quarter ended June 30, 2006 that has materially affected, or isreasonably likely to materially affect, our internal control over financialreporting.

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**Part II.  Other Information**

**Item 1A.         Risk Factors**

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

Therisks and uncertainties described below are not the only risks we face.  Additional risks and uncertainties notpresently known to us or currently deemed immaterial may also impair ourbusiness operations.  If any of thefollowing risks actually occur, our financial condition and operating resultscould be materially adversely affected.

***We expect to incursignificant operating losses in the near future.***

Although we have been profitable during the first twoquarters of 2006, we expect to incur net losses in future quarters as weincrease our research and development spending on an internal R&D initiative.  Moreover, as we continue to pursue ourbusiness strategy of acquiring or developing new medical devices to addresscardiac and vascular related markets, we may continue to incur expenses thatexceed the revenues we generate.  Wecannot provide any assurance that we will be successful with our businessstrategy, that any new products under development will be successful or that wewill ever return to profitability.

***Our company is currently dependent on oneprincipal customer.***

Pursuantto the terms of our TMR distribution agreement with Edwards, Edwards is ourexclusive distributor for our HL2 TMR laser and TMR kits in the UnitedStates.  In addition, we are theexclusive manufacturer of the current version of the Optiwave 980 laser consolefor Edwards.  As a result of theseexclusive arrangements, Edwards accounted for 91% and 86%, respectively, of ourtotal revenues in the three and six months ended June 30, 2006 and 89% in theyear ended December 31, 2005, and we expect Edwards to account for thesignificant majority of our revenue in the near future.  If our relationship with Edwards does notprogress as anticipated, or if Edwards’ sales and marketing strategies fail togenerate sales of our products in the future, our revenue will decrease significantlyand our business, financial condition and results of operations will beseriously harmed.

***Our company iscurrently dependent on one principal product line to generate revenues.***

We currently sell one principal product line, whichconsists of two patented high-powered carbon dioxide lasers and related TMRdisposable kits known as the Heart Laser Systems, which account for themajority of our total revenue. Approximately 95% and 96%, respectively, of our revenues in the threeand six months ended June 30, 2006 and 89% in the year ended December 31, 2005,were derived from the sales and service of our Heart Laser Systems.  This absence of a diversified product linemeans that we are directly and materially impacted by changes in the market forHeart Laser Systems.

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***Our ability to realize future revenues fromthe Optiwave 980 is dependent upon Edwards successfully launching this newproduct into an existing market with a new sales team.***

Edwards has onlyrecently completed its marketing evaluations of the Optiwave 980 System and, asa result, has a limited amount of experience selling this new product into theU.S. market.  Edwards must effectivelytrain a new sales team to market the Optiwave 980 System and faces significantcompetition from several other companies that have been selling competitivenon-laser based technologies for several years. We cannot assure you that Edwards will successfully commercialize theOptiwave 980 System or that we will ever receive any or all of the royaltyrevenue we negotiated to receive from the sale of disposable products under ourroyalty agreement with Edwards.

***Our company is dependent oncertain 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 Optiwave 980 System, are only available from one supplier,and we have no assurance that we will be able to source any of our sole-sourcedcomponents from additional suppliers.  Weare dependent upon our sole suppliers to perform their obligations in a timelymanner.  In the past, we have experienceddelays in product delivery from our sole suppliers and, because we do not havean alternative supplier to produce these products for us, we have little leverageto enforce timely delivery. Any delay in product delivery or other interruptionin supply from these suppliers could prevent us from meeting our commercialdemands for our products, which could have a material adverse effect on ourbusiness, 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 our current suppliers or establishrelationships with additional suppliers on commercially reasonable terms, if atall, and such difficulties may seriously harm our business, financial conditionand results of operations.

***We are dependent upon our key personnel andwill need to hire additional key personnel in the near future.***

Our ability to operate ourbusiness successfully depends in significant part upon the retention andmotivation of certain key technical, regulatory, production and managerialpersonnel and consultants and our ongoing ability to hire and retain additionalqualified personnel in these areas. Competition for such personnel is intense,particularly in the Greater Boston area. We cannot be certain that we will beable to attract such personnel and the loss of any of our current key employeesor consultants could have a significant adverse impact on our business.

***Our company may be unable to raise needed funds.***

As of June 30, 2006, we had cash, cash equivalents andshort-term investments totaling $10,396,000. Based on our current operatingplan, we anticipate that our existing capital resources should be sufficient tomeet our working capital requirements for at least the next 12 months.  However, if our business does not progress inaccordance 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 our business,financial condition and results of 

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operations could be materially and adverselyaffected.  To the extent that we raiseadditional capital by issuing equity or convertible securities, ownershipdilution to our shareholders will result. To the extent that we raise additional capital through the incurrence ofdebt, our activities may be restricted by the repayment obligations and otherrestrictive covenants related to the debt.

***In order to competeeffectively, our current and future products need to gain commercialacceptance.***

TMR and surgical ablation for cardiac arrhythmias arestill both novel technologies.  Ourcurrent and planned future products may never achieve widespread commercialacceptance.  To be successful, we andEdwards need to:

·                  demonstrate tothe medical community in general, and to heart surgeons and cardiologists inparticular, that TMR and surgical tissue ablation for cardiac arrhythmias areprocedures that are effective, relatively safe and cost effective;

·                  supportthird-party efforts to document the medical processes by which TMR proceduresrelieve angina and surgical tissue ablation cures cardiac arrhythmias;

·                  have more heartsurgeons trained to perform TMR procedures using the Heart Laser Systems andsurgical tissue ablation procedures using the Optiwave 980 System; and

·                  maintain andexpand third-party reimbursement for the TMR procedure.

To date, only a limited number of heart surgeons havebeen trained in the use of TMR using the Heart Laser Systems and cardiac tissueablation procedures using the Optiwave 980 System.  We are dependent on Edwards to expand relatedmarketing and training efforts in the U.S. for the use of our products.

The Heart Laser Systems have not yet receivedwidespread commercial acceptance.  Webelieve that concerns over the lack of a consensus view on the reason orreasons why a TMR procedure relieves angina in patients who undergo theprocedure has limited demand for and use of the Heart Laser Systems. Untilthere is consensus, if ever, of the medical processes by which TMR proceduresrelieve angina, we believe some hospitals may delay the implementation of a TMRprogram.

If we are unable to achieve widespread commercialacceptance of the Heart Laser Systems or the Optiwave 980 System, our business,financial condition and results of operations will be materially and adverselyaffected.

***Our primary competitor in TMR may obtainFDA approval to market a new device, the impact of which is uncertain on thefuture adoption rate of TMR.***

Ourprimary TMR competitor, CardioGenesis, is attempting to obtain FDA approval tomarket their “percutaneous” method of performing myocardial revascularization,previously known as PMR, and recently rebranded as PMC (percutaneous myocardialchanneling), which would provide a less invasive method of creating channels inthe heart.  If PMC can be shown to be safe and effective and is approvedby the FDA, it would eliminate the need in certain patients to make an incisionin the chest, reducing costs and speeding recovery.  It is unclear what impact, 

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if any, an approval of a PMC device would have on thefuture adoption rate for TMR procedures. If PMC is approved, it could erode thepotential TMR market which would have a material adverse effect on ourbusiness, financial condition and results of operations.

***Rapid technologicalchanges in our industry could make our products obsolete.***

Our industry is characterized by rapid technologicalchange and intense competition.  Newtechnologies and products and new industry standards will develop at a rapidpace, which could make our current and future planned products obsolete. Theadvent of new devices and procedures and advances in new drugs and geneticengineering are especially concerning competitive threats.  Our future success will depend upon ourability to develop and introduce product enhancements to address the needs ofour customers.  Material delays inintroducing product enhancements may cause customers to forego purchases of ourproducts and purchase those of our competitors.

Many potential competitors have substantially greaterfinancial resources and are in a better financial position to exploit marketingand research and development opportunities. In addition, we are aware that other companies are developing or alreadyhave developed proprietary systems for the treatment of cardiac arrhythmias,and specifically AF, that may be safer, clinically more effective, easier andmore cost effective to use and, in the case of percutaneous devices, lessinvasive than the systems we market.

***We must receive andmaintain government clearances or approvals in order to market our products.***

Our products and our manufacturing activities aresubject to extensive, rigorous and changing federal and state regulation in theU.S. and to similar regulatory requirements in other major internationalmarkets, including the European Union and Japan.  These regulations and regulatory requirementsare broad in scope and govern, among other things:

·                  product designand development;

·                  product testing;

·                  productlabeling;

·                  product storage;

·                  premarketclearance and approval;

·                  advertising andpromotion; and

·                  product salesand distribution.

Furthermore, regulatory authorities subject a marketedproduct, its manufacturer and the manufacturing facilities to continual reviewand periodic inspections.  We are subjectto ongoing FDA requirements, including required submissions of safety and otherpost-market information and reports, registration requirements, Quality Systemsregulations, and recordkeeping requirements. The FDA’s Quality Systemsregulations include requirements relating to quality control and qualityassurance, as well as the corresponding maintenance of records anddocumentation.  Edwards, our distributor,depending on its activities, is also subject to certain requirements under theFederal Food, Drug, and Cosmetic Act and the regulations promulgatedthereunder, and state laws and registration requirements covering thedistribution of our products. Regulatory agencies may change existingrequirements or adopt new requirements or policies that could affect ourregulatory responsibilities or the regulatory responsibilities of a distributorlike Edwards.  We may be slow to adapt ormay not be able to adapt to these changes or new requirements.

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Later discovery of previously unknown problems withour products, manufacturing processes, or our failure to comply with applicableregulatory requirements may result in enforcement actions by the FDA and otherinternational regulatory authorities, including, but not limited to:

·                  warning letters;

·                  patient orphysician notification;

·                  restrictions onour products or manufacturing processes;

·                  voluntary ormandatory recalls;

·                  productseizures;

·                  refusalto approve pending applications or supplements to approved applications that wesubmit;

·                  refusal topermit the import or export of our products;

·                  fines;

·                  injunctions;

·                  suspension orwithdrawal of marketing approvals or clearances; and

·                  civil andcriminal penalties.

Should any of these enforcement actions occur, ourbusiness, financial condition and results of operations could be materially andadversely affected.

To date, the following regulatory approvals have beenobtained for our products:

***Heart Laser Systems***

*UnitedStates —*We received FDA approval to market the HL1 HeartLaser System in August 1998 and the HL2 Heart Laser System in January2001.  However, although we have receivedFDA approval, the FDA:

·                  has restrictedthe use of the Heart Laser Systems by not allowing us to market these productsto treat patients whose condition is amenable to conventional treatments, suchas heart bypass surgery, stenting and angioplasty; and

·                  could imposeadditional restrictions or reverse its ruling and prohibit use of the HeartLaser Systems at any time.

*Europe —*We receivedthe CE Mark from the European Union for the HL1 and HL2 in March 1995 andFebruary 2001, respectively.  However:

·                  the EuropeanUnion could impose additional restrictions or reverse its ruling and prohibituse of the Heart Laser Systems at any time; and

·                  France hasprohibited, and other European Union countries could prohibit or restrict, useof the Heart Laser Systems.

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*Japan —*Our HL1Heart Laser System received marketing approval from the Japanese Ministry ofHealth, Labor and Welfare (“MHLW”) in May 2006. However, the MHLW could imposerestrictions in the future or reverse its ruling and prohibit use of the HeartLaser Systems at any time.

In addition, it is unclear what impact theintroduction of the HL2 into the U.S. and other international markets will haveon the ability of our Japanese distributor to market our older, firstgeneration HL1 in Japan. Although our Japanese distributor has indicated to usthat it plans to seek MHLW approval in the future to market our newer HL2, wecan provide no assurance that the distributor will be successful in obtainingthe necessary approvals or how long it may take to secure the requiredapprovals.

***Optiwave 980 System***

*United States —*The FDA has given clearance to the Optiwave980 System through the 510(k) premarket notification process with indicationsfor use as a surgical instrument for coagulation of soft tissue, includingcardiac tissue, in conjunction with or without endoscopic equipment in thecontact or non-contact mode in open or closed surgical procedures.

Although the Optiwave 980 System has received clearance from the FDAonly for the indications of use stated above, physicians, under the practice ofmedicine exception, may use the device 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 Optiwave 980System that would allow Edwards to make claims or otherwise market this devicefor the treatment of AF. We are aware of several other companies that haveannounced their plans to conduct clinical trials in support of a labeling claimthat would allow them to market their devices for the treatment of AF ifclearance is obtained from the FDA.

In the event these other competitors are successful in obtainingspecific indications of use for their devices in the treatment of AF, theOptiwave 980 System may be at a competitive marketing disadvantage until suchtime, if ever, that Edwards conducts a clinical trial, submits sufficient datato the FDA by means of a new 510(k) and obtains clearance to market theOptiwave 980 System for the treatment of AF. We cannot provide any assurancethat Edwards will ever conduct such a clinical trial or, if they do, that thedata they obtain and submit to the FDA will be sufficient for the FDA to expandthe current indications of use and provide clearance for the Optiwave 980System to be marketed for the treatment of AF. Also, we cannot assure you thateven if such clearance is obtained, that it will be obtained in a timely enoughfashion for our products to remain competitive in the marketplace.

*Europe —*The Optiwave 980 System cannot be marketed in the EU until such time asit receives CE Mark approval. Edwards needs to complete and submit the relevanttechnical documentation to the appropriate certifying body in order to be ableto apply the CE Mark to the product.  Ifapproval to apply the CE Mark is granted, the Optiwave 980 System will then beable to be distributed in the EU.

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*** ***

***Changes in third party reimbursementfor either TMR or cardiac tissue ablation procedures could materially affectfuture demand for our products.***

Demand for medical devices is often affected bywhether third party reimbursement is available for the devices and relatedprocedures.  Currently Medicare coverageis provided for TMR when it is performed as a sole therapy treatment.  In addition, when two or more medicalprocedures are performed in combination with each other, Medicare rulesgenerally allow hospitals to bill for whichever of the two procedures carriesthe higher reimbursement amount. Therefore, in situations where sole therapyTMR reimbursement rates exceed that provided for bypass surgery alone, ifhospitals perform a combination procedure where both bypass surgery andadjunctive TMR are performed on a patient, the hospital is able to bill for thehigher TMR procedure reimbursement payment. In these instances, the doctor alsocan bill an additional amount for performing multiple procedures.

Certainprivate insurance companies and health maintenance organizations also currentlyprovide reimbursement for TMR procedures performed with our products and physician reimbursement codes have beenestablished for both surgical procedures.

Cardiactissue ablation procedures, such as those that are expected to be performedusing the Optiwave 980 System, are also currently reimbursed by Medicare whenperformed as a sole therapy.  Ininstances where a surgeon might perform a cardiac tissue ablation procedure incombination with another heart related procedure, such as a valve replacementor repair, we believe the other procedure will normally carry a higherreimbursement and, therefore, will be the procedure that the hospital bills toMedicare.

No assurance can be given, however, that thesepayers will continue to reimburse healthcare providers who perform TMR orcardiac tissue ablation procedures using our products now or in the future.Further, no assurance can be given that additional payers will reimbursehealthcare providers who perform TMR or cardiac tissue ablation proceduresusing our products or that reimbursement, if provided, will be timely oradequate.

Shouldthird party insurance reimbursement for either TMR or cardiac tissue ablationprocedures be reduced or eliminated in the future, our business, financialcondition and results of operations would be materially and adversely affected.

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.

***Asserting anddefending intellectual property rights may impact our results of operations.***

In our industry, competitors often assert intellectualproperty infringement claims against one another and occasionally attempt tochallenge, invalidate or circumvent patents that are issued to otherparties.  The success of our businessdepends on our ability to successfully defend our intellectual property.  Future litigation may have a material impacton our financial condition even if we are successful in marketing our products.We may not be successful in defending or asserting our intellectual propertyrights.

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An adverse outcome in any litigation or interferenceproceeding could subject us to significant liabilities to third parties andrequire us to cease using the technology that is at issue or to license thetechnology from third parties.  Inaddition, a finding that any of our intellectual property is invalid couldallow our competitors to more easily and cost-effectively compete with us.  Thus, an unfavorable outcome in any patentlitigation or interference proceeding could have a material adverse effect onour business, financial condition or results of operations.

The cost to us of any patent litigation orinterference proceeding could be substantial. Uncertainties resulting from the initiation and continuation of patentlitigation or interference proceedings could have a material adverse effect onour ability to compete in the marketplace. Patent litigation and interference proceedings may also absorbsignificant management time.

***We may be subjectto product liability lawsuits; our insurance may not be sufficient to coverdamages.***

We may be subject to product liability claims.  Such claims may absorb significant managementtime 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 inthe future may not be available on acceptable terms, if at all. If a successfulproduct liability claim or series of claims exceeds our insurance coverage, itcould have a material adverse effect on our business, financial condition andresults of operations.

***We are subject torisks associated with international operations.***

A portion of our product sales are generated fromoperations outside of the U.S.  Establishing, maintaining and expandinginternational sales can be expensive. Managing and overseeing foreign operations are difficult and productsmay not receive market acceptance.  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 rights in foreign countries may bemore difficult 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.

***We will soon have to comply withinternal controls evaluations and attestation requirements.***

Pursuantto Section 404 of the Sarbanes-Oxley Act of 2002, we will be required,beginning with our fiscal year ending December 31, 2007, to perform anevaluation of our internal controls over financial reporting and have ourindependent registered public accounting firm attest to such evaluation.  We are developing a program to perform thisevaluation in order to comply with these requirements. Compliance with theserequirements is expected to be expensive and time-consuming.  If we fail to timely complete thisevaluation, or if our independent registered public accounting firm cannottimely attest to our evaluation, we could be 

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subject to regulatory action and public confidence inus could be adversely affected and our stock price could decline.  In addition, any failure to implementrequired new or improved controls, or difficulties encountered in theirimplementation, could harm our operating results or cause us to fail to meetour reporting obligations.

***Because we are incorporated in Canada, youmay not be able to enforce judgments against us and our Canadian directors.***

Under Canadian law, you may not be able to enforce ajudgment issued by courts in the U.S. against us or our Canadian directors. Thestatus of the law in Canada is unclear as to whether a U.S. citizen can enforcea judgment from a U.S. court in Canada for violations of U.S. securities laws.A separate suit may need to be brought directly in Canada.

***Our stock price has historically fluctuated and may continueto fluctuate significantly in the future which may result in losses for ourinvestors.***

Our stock price has been and may continue to bevolatile. Some of the factors that can affect our stock price are:

·                  the announcementof new products, services or technological innovations by us or ourcompetitors;

·                  actual oranticipated quarterly increases or decreases in revenue, gross margin orearnings, and changes in our business, operations or prospects;

·                  speculation oractual news announcements in the media or industry trade journals about ourcompany, our products, the TMR or cardiac ablation procedures or changes inreimbursement policies by Medicare and/or private insurance companies;

·                  announcementsrelating to strategic relationships or mergers;

·                  conditions ortrends in the medical device industry;

·                  changes in theeconomic performance or market valuations of other medical device companies;and

·                  general marketconditions or domestic or international macroeconomic and geopolitical factorsunrelated to our performance.

***The market price ofour stock may fall if shareholders sell their stock.***

Certaincurrent shareholders hold large amounts of our stock, which they could sell inthe public market from time to time. Sales of a substantial number of shares of our common stock within ashort period of time could cause our stock price to fall.  In addition, the sale of these shares couldimpair our ability to raise capital through the sale of additional stock.

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

Wehave never paid any cash dividends on our common stock. We currently intend toretain all future earnings, if any, for use in our business and do not expectto pay any dividends in the foreseeable future.

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**Item 4.            Submission of Matters to a Vote of Security Holders**

On May 17, 2006, the Companyheld its 2006 Annual Meeting of Shareholders (the “Shareholders Meeting”).  At the Shareholders Meeting, the followingmatters were approved by the vote specified below:

1.                                       Benjamin L. Holmes, Alan H. Magazine and EdwardH. Pendergast were elected as Class II directors and will hold office until theannual meeting of shareholders in 2009 or until their successors are dulyelected and qualified.  Mr. Holmesreceived 26,217,802 shares of common stock voting in favor of his election and506,787 shares of common stock were withheld. Mr. Magazine received 26,217,428 shares of common stock voting in favorof his election and 507,161 shares of common stock were withheld.  Mr. Pendergast received 26,217,428 shares ofcommon stock voting in favor of his election and 507,161 shares of common stockwere withheld.  The remaining terms ofKevin J. Dunn, Brent Norton, M.D., Robert I. Rudko, Ph.D. and Mark R. Tauschercontinued after the Shareholders Meeting.

2.                                       The selection of Vitale, Caturano & Company,Ltd. as the Company’s independent registered public accounting firm for theyear ending December 31, 2006 and the authorization of the Audit Committee ofthe Board of Directors to fix the remuneration to be paid to the auditors wereapproved.  The votes were cast asfollows: 26,324,481 shares of common stock were voted for the approval, 375,527shares of common stock were voted against the approval and 24,581 shares ofcommon stock abstained from the vote.

**Item 6.          Exhibits**
| 10.1   |   | Second Amendment to Shareholders Agreement, dated  April 6, 2006, by and among the Registrant and Edwards Lifesciences  Corporation, incorporated by reference to the Registrant’s quarterly report  on Form 10-Q for the quarter ended March 31, 2006, as previously filed with  the Securities and Exchange Commission. |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                           |
| 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   |   | Certifications 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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**SIGNATURES**

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.
|                      |   | PLC SYSTEMS INC. |
|----------------------|--------|------------------|
|                 |   |             |   |   |
| Date: August 9, 2006 |   | 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            |       | Second Amendment to Shareholders Agreement, dated  April 6, 2006, by and among the Registrant and Edwards Lifesciences  Corporation, incorporated by reference to the Registrant’s quarterly report  on Form 10-Q for the quarter ended March 31, 2006, as previously filed with  the Securities and Exchange Commission. |
|            |       |                                                                                                                                                                                                                                                                                                                           |
| 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            |       | Certifications 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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