**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

 
| **     ****ý** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934.**                                                                                                                                                                                         |
|----------------------------------------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                         |                                                                                                                                                                                                                                                                                            |
| ** **                                   | **For the  quarterly period ended June 30, 2005.**                                                                                                                                                                                                                                         |
| ** **                                   | ** **                                                                                                                                                                                                                                                                                      |
| **OR**                                       |
|                                         |                                                                                                                                                                                                                                                                                            |
| **     ****o**      | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.**                                                                                                                                                                                        |
|                                         |                                                                                                                                                                                                                                                                                            |
|                                         | **For the transition period from                        to                      ** |

 

**Commission File Number: 1-11388**

 

**PLCSYSTEMS INC.**

(Exact Name of Registrantas Specified in Its Charter)

 
| **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’s telephone  number, including area code: **(508) 541-8800** |

 

Indicate by check mark whether the registrant: (1) has filed allreports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.  **Yes****ý****No****o**

 

Indicate by check mark whether the registrant is an accelerated filer (asdefined in Rule 12b-2 of the Exchange Act) **Yes****o****No****ý**

 

Indicate the number of shares outstanding of each of the issuer’sclasses of common stock, as of the latest practicable date.

 
| **Class**                   | ** ** | **Outstanding at August 5, 2005** |
|-----------------------------|------------|----------------------------------------|
| Common Stock, no par  value |       | 30,078,775                             |

 

 

----

 

**PLC SYSTEMS INC.**

 

**Index**

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

 

2

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**Item 1.****           FinancialStatements**

 

**PLC SYSTEMS INC.**

CONDENSED CONSOLIDATEDBALANCE SHEETS

(In thousands)

(Unaudited)

 
| ** **                                                                                                                                                     | ** ** | **June 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| **ASSETS**                                                                                                                                                     |       |                    |       |                        |       |
| Current assets:                                                                                                                                                |       |                    |       |                        |       |
| Cash and cash  equivalents                                                                                                                                     |       | $                       | 2,645      |                        | $          | 9,678 |   |
| Short-term  investments                                                                                                                                        |       | 6,900                   |       | —                      |       |
| Accounts  receivable – Edwards                                                                                                                            |       | 1,099                   |       | 1,144                       |       |
| Accounts  receivable – other, net of allowance of $90 and $104 as of June 30, 2005  and December 31, 2004, respectively                         |       | 212                     |       | 261                         |       |
| Inventories, net                                                                                                                                               |       | 1,146                   |       | 1,112                       |       |
| Prepaid expenses  and other current assets                                                                                                                     |       | 868                     |       | 592                         |       |
| Total current  assets                                                                                                                                          |       | 12,870                  |       | 12,787                      |       |
|                                                                                                                                                           |       |                    |       |                        |       |
| Equipment,  furniture and leasehold improvements, net                                                                                                          |       | 268                     |       | 293                         |       |
| Other assets                                                                                                                                                   |       | 235                     |       | 247                         |       |
| Total assets                                                                                                                                                   |       | $                       | 13,373     |                        | $          | 13,327 |   |
| ** **                                                                                                                                                     | ** ** | ** **              | ** ** | ** **                  | ** ** |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                  | ** ** | ** **              | ** ** | ** **                  | ** ** |
| Current  liabilities:                                                                                                                                          |       |                    |       |                        |       |
| Accounts payable                                                                                                                                               |       | $                       | 393        |                        | $          | 328 |   |
| Accrued  compensation                                                                                                                                          |       | 561                     |       | 430                         |       |
| Accrued other                                                                                                                                                  |       | 291                     |       | 301                         |       |
| Deferred revenue  – Edwards                                                                                                                               |       | 1,457                   |       | 999                         |       |
| Deferred revenue  – other                                                                                                                                 |       | 66                      |       | 71                          |       |
| Total current  liabilities                                                                                                                                     |       | 2,768                   |       | 2,129                       |       |
|                                                                                                                                                           |       |                    |       |                        |       |
| Deferred revenue  – Edwards                                                                                                                               |       | 4,087                   |       | 4,181                       |       |
| Deferred revenue  – other                                                                                                                                 |       | 188                     |       | 188                         |       |
| Total long-term  liabilities                                                                                                                                   |       | 4,275                   |       | 4,369                       |       |
| 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, 30,079 and 30,068 shares issued and  outstanding as of June 30, 2005 and December 31, 2004 |       | 93,737                  |       | 93,731                      |       |
| Accumulated  deficit                                                                                                                                           |       | (87,056                 | )          | (86,582                     | )          |
| Accumulated  other comprehensive loss                                                                                                                          |       | (351                    | )          | (320                        | )          |
| Total  stockholders’ equity                                                                                                                               |       | 6,330                   |       | 6,829                       |       |
| Total  liabilities and stockholders’ equity                                                                                                               |       | $                       | 13,373     |                        | $          | 13,327 |   |

 

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

 

3

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**PLC SYSTEMS INC.**

CONDENSED CONSOLIDATEDSTATEMENTS OF OPERATIONS

(In thousands, except pershare data)

(Unaudited)

 
| ** **                           | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|--------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                           | ** ** | **2005**                              | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenues:                            |       |                                  |       |                                |       |   |   |   |   |
| Product sales –  Edwards        |       | $                                     | 1,438      |                                | $          | 1,224 |   | $ | 2,846 |   | $ | 2,586 |   |
| Product sales –  other          |       | 129                                   |       | 130                                 |       | 279 |   | 299 |   |
| Service fees –  Edwards         |       | 360                                   |       | 308                                 |       | 671 |   | 661 |   |
| Service fees –  other           |       | 55                                    |       | 134                                 |       | 129 |   | 159 |   |
| Total revenues                       |       | 1,982                                 |       | 1,796                               |       | 3,925 |   | 3,705 |   |
|                                 |       |                                  |       |                                |       |   |   |   |   |
| Cost of  revenues:                   |       |                                  |       |                                |       |   |   |   |   |
| Product sales –  Edwards        |       | 531                                   |       | 494                                 |       | 1,016 |   | 1,028 |   |
| Product sales –  other          |       | 69                                    |       | 81                                  |       | 136 |   | 137 |   |
| Service fees –  Edwards         |       | 144                                   |       | 140                                 |       | 282 |   | 287 |   |
| Service fees –  other           |       | 46                                    |       | 32                                  |       | 84 |   | 61 |   |
| Total cost of  revenues              |       | 790                                   |       | 747                                 |       | 1,518 |   | 1,513 |   |
|                                 |       |                                  |       |                                |       |   |   |   |   |
| Gross profit                         |       | 1,192                                 |       | 1,049                               |       | 2,407 |   | 2,192 |   |
|                                 |       |                                  |       |                                |       |   |   |   |   |
| Operating  expenses:                 |       |                                  |       |                                |       |   |   |   |   |
| Selling, general  and administrative |       | 897                                   |       | 866                                 |       | 1,777 |   | 1,856 |   |
| Research and  development            |       | 649                                   |       | 516                                 |       | 1,220 |   | 1,045 |   |
| Total operating  expenses            |       | 1,546                                 |       | 1,382                               |       | 2,997 |   | 2,901 |   |
|                                 |       |                                  |       |                                |       |   |   |   |   |
| Loss from  operations                |       | (354                                  | )          | (333                                | )          | (590 | ) | (709 | ) |
|                                 |       |                                  |       |                                |       |   |   |   |   |
| Other income,  net                   |       | 64                                    |       | 82                                  |       | 116 |   | 108 |   |
|                                 |       |                                  |       |                                |       |   |   |   |   |
| Net loss                             |       | $                                     | (290       | )                                   | $          | (251 | ) | $ | (474 | ) | $ | (601 | ) |
|                                 |       |                                  |       |                                |       |   |   |   |   |
| Basic and  diluted loss per share    |       | $                                     | (0.01      | )                                   | $          | (0.01 | ) | $ | (0.02 | ) | $ | (0.02 | ) |
|                                 |       |                                  |       |                                |       |   |   |   |   |
| Average shares  outstanding:         |       |                                  |       |                                |       |   |   |   |   |
| Basic                                |       | 30,070                                |       | 30,056                              |       | 30,069 |   | 29,990 |   |
| Diluted                              |       | 30,070                                |       | 30.056                              |       | 30,069 |   | 29,990 |   |

 

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

 

4

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**PLC SYSTEMS INC.**

CONDENSED CONSOLIDATEDSTATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

 
| ** **                                                                                  | ** ** | **Six Months Ended  June 30,** | ** ** |
|---------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                  | ** ** | **2005**                            | ** ** | **2004** | ** ** |
| Operating  activities:                                                                      |       |                                |       |   |   |
| Net loss                                                                                    |       | $                                   | (474       | ) | $ | (601 | ) |
|                                                                                        |       |                                |       |   |   |
| Adjustments to  reconcile net loss to net cash provided by (used for) operating activities: |       |                                |       |   |   |
| Depreciation and  amortization                                                              |       | 68                                  |       | 71 |   |
|                                                                                        |       |                                |       |   |   |
| Change in assets  and liabilities:                                                          |       |                                |       |   |   |
| Accounts  receivable – Edwards                                                         |       | 44                                  |       | 142 |   |
| Accounts  receivable – other                                                           |       | 64                                  |       | (83 | ) |
| Inventories                                                                                 |       | (35                                 | )          | (262 | ) |
| Prepaid expenses  and other assets                                                          |       | (276                                | )          | (173 | ) |
| Accounts payable                                                                            |       | 65                                  |       | 254 |   |
| Deferred revenue  – Edwards                                                            |       | 364                                 |       | 4,522 |   |
| Deferred revenue  – other                                                              |       | (1                                  | )          | 13 |   |
| Accrued  liabilities                                                                        |       | 121                                 |       | 15 |   |
| Net cash  provided by (used for) operating activities                                       |       | (60                                 | )          | 3,898 |   |
|                                                                                        |       |                                |       |   |   |
| Investing  activities:                                                                      |       |                                |       |   |   |
| Purchase of  short-term investments                                                         |       | (6,900                              | )          | — |   |
| Purchase of  equipment                                                                      |       | (30                                 | )          | (104 | ) |
| Net cash used  for investing activities                                                     |       | (6,930                              | )          | (104 | ) |
|                                                                                        |       |                                |       |   |   |
| Financing  activities:                                                                      |       |                                |       |   |   |
| Net proceeds  from sales of common shares                                                   |       | 6                                   |       | 90 |   |
| Net cash  provided by financing activities                                                  |       | 6                                   |       | 90 |   |
|                                                                                        |       |                                |       |   |   |
| Effect of exchange  rate changes on cash and cash equivalents                               |       | (49                                 | )          | (10 | ) |
| Net increase  (decrease) in cash and cash equivalents                                       |       | (7,033                              | )          | 3,874 |   |
|                                                                                        |       |                                |       |   |   |
| Cash and cash  equivalents at beginning of period                                           |       | 9,678                               |       | 6,377 |   |
| Cash and cash  equivalents at end of period                                                 |       | $                                   | 2,645      |   | $ | 10,251 |   |

 

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

 

5

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**PLC SYSTEMS INC.**

NOTES TO CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS

June 30, 2005

 

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

 

PLC Systems Inc. (“PLC” orthe “Company”) is a medical device company specializing in innovativetechnologies for the cardiac and vascular markets.  The Company currently manufactures lasers foruse in the treatment of cardiovascular disease. PLC pioneered the *CO2 Heart LaserSystem* (the “Heart Laser System”) that cardiac surgeons use toperform carbon dioxide (CO2) transmyocardial revascularization (“TMR”)to alleviate symptoms of severe angina. In addition, PLC is completing the development of and manufacturing theOptiwave 980 cardiac laser ablation system (“Optiwave 980 System”) under anagreement with Edwards Lifesciences LLC (“Edwards”).  Following commercial release, the Optiwave980 System is expected to be utilized by surgeons to ablate cardiac tissue as ameans to treat certain heart arrhythmias.

 

Edwards is the Company’sexclusive worldwide distributor for all surgical cardiac ablation products and,in the United States, acts as the Company’s exclusive distributor for TMR products.Edwards is also the Company’s largest shareholder, owning approximately 18% ofits outstanding common stock as of June 30, 2005, and has a representativeon the Board of Directors.

 

***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 RegulationS-X.  Accordingly, they do not includeall of the information and footnotes required by generally accepted accountingprinciples for complete financial statements. In the opinion of management, all adjustments (consisting of normalrecurring adjustments) considered necessary for a fair presentation have beenincluded.  Operating results for thethree and six months ended June 30, 2005 are not necessarily indicative ofthe results that may be expected for the year ending December 31,2005.  These financial statements shouldbe read in conjunction with the consolidated financial statements and footnotesthereto included in the Company’s Annual Report on Form 10-K for the yearended December 31, 2004.  Certainprior year amounts have been reclassified to conform to the current year’s presentation.

 

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

 

In February 2004, theCompany signed an agreement with Edwards to assume development of the Optiwave980 System.  Under the terms of theagreement, the Company will have exclusive manufacturing rights to build theOptiwave 980 System and other related surgical products. The Company will beresponsible, among other things, for ongoing research and development andmanufacture of the product and for obtaining regulatory approvals.  Edwards will be responsible for the approval,funding and conduct of any clinical studies designed to obtain data in supportof a new product approval or clearance as required by the FDA or otherregulatory body.

 

6

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In conjunction with signingthis new agreement, the terms of the Company’s TMR distribution agreement withEdwards were modified to (1) extend the term of the agreement until atleast October 17, 2017 and (2) reduce the Company’s share of revenueon TMR kits sold to hospitals. The Company received as consideration fromEdwards, a lump-sum payment of $4,533,333, which was recorded as deferredrevenue in the Company’s Consolidated Balance Sheet.  See Note 8, “Revenue Recognition”.

 

***4.******                                      Lossper Share***

 

For the three and six monthsended June 30, 2005 and 2004, basic and diluted loss per share have beencomputed using only the weighted average number of common shares outstandingduring the period without giving effect to any potential future issues ofcommon stock related to stock option programs and warrants since theirinclusion would be antidilutive.

 

For the three months ended June 30,2005 and 2004, 5,818,422 and 6,190,422 shares, respectively, and for the sixmonths ended June 30, 2005 and 2004, 5,818,422 and 6,190,422 shares,respectively, attributable to outstanding stock options and warrants wereexcluded from the calculation of diluted loss per share because the effect wasantidilutive.  The following table setsforth the computation of basic and diluted loss per share:

 
| ** **                                              | ** ** | **Three Months Ended  June 30,**         | ** ** | **Six Months Ended  June 30,** | ** ** |
|---------------------------------------------------------|------------|-----------------------------------------------|------------|-------------------------------------|------------|
| ** **                                              | ** ** | **2005**                                      | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                              | ** ** | **(In thousands, except earnings per share)** | ** ** |
| Net loss  available for common shareholders             |       | $                                             | (290       | )                                   | $          | (251 | ) | $ | (474 | ) | $ | (601 | ) |
| Weighted average  outstanding shares of common stock    |       | 30,070                                        |       | 30,056                              |       | 30,069 |   | 29,990 |   |
| Dilutive effect  of employee stock options and warrants |       | —                                        |       | —                              |       | — |   | — |   |
| Common stock and  common stock equivalents              |       | 30,070                                        |       | 30,056                              |       | 30,069 |   | 29,990 |   |
| Loss per share:                                         |       |                                          |       |                                |       |   |   |   |   |
| Basic                                                   |       | $                                             | (0.01      | )                                   | $          | (0.01 | ) | $ | (0.02 | ) | $ | (0.02 | ) |
| Diluted                                                 |       | $                                             | (0.01      | )                                   | $          | (0.01 | ) | $ | (0.02 | ) | $ | (0.02 | ) |

 

***5.******                                      Stock-BasedCompensation***

 

The Company grants stockoptions for a fixed number of shares to employees and certain other individualswith exercise prices equal to the fair value of the shares at the dates ofgrant. The Company has adopted the disclosure-only provisions of Statement ofFinancial Accounting Standards No. 123, *Accountingfor Stock-based Compensation* (“SFAS 123”), as amended, and presentlyaccounts for its stock option plans in accordance with the provisions ofAccounting Principles Board Opinion 25, *Accounting for StockIssued to Employees*(“APB 25”).

 

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:

 

7

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| ** **                                                                                                           | ** ** | **Three Months Ended  June 30,**     | ** ** | **Six Months Ended  June 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                                           | ** ** | **2005**                                  | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                                                           | ** ** | **(In thousands, except per share data)** | ** ** |
| Net loss  attributable to common stockholders—  As reported                                                     |       | $                                         | (290       | )                                   | $          | (251 | ) | $ | (474 | ) | $ | (601 | ) |
| Deduct total  stock-based compensation expense determined under fair value based method for  all stock option awards |       | (132                                      | )          | (359                                | )          | (166 | ) | (392 | ) |
| Net loss  attributable to common stockholders—  Pro forma                                                       |       | $                                         | (422       | )                                   | $          | (610 | ) | $ | (640 | ) | $ | (993 | ) |
| Loss per basic  and diluted share attributable to common stockholders—  As reported                             |       | $                                         | (0.01      | )                                   | $          | (0.01 | ) | $ | (0.02 | ) | $ | (0.02 | ) |
| Loss per basic  and diluted share attributable to common stockholders—  Pro forma                               |       | $                                         | (0.01      | )                                   | $          | (0.02 | ) | $ | (0.02 | ) | $ | (0.03 | ) |

 

The fair value of issued options at the date of grantwas estimated using the Black-Scholes model with the following weighted averageassumptions:

 

| ** **               | ** ** | **Three Months  Ended June 30,** | ** ** |
|--------------------------|------------|---------------------------------------|------------|
| ** **               | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| Expected life  (years)   |       | 3                                     |       | 3 |   |
| Interest rate            |       | 3.68                                  | %          | 2.53 | % |
| Volatility               |       | .401                                  |       | .734 |   |
| Expected  dividend yield |       | None                                  |       | None |   |

 

***Recent AccountingPronouncement***

 

On December 16, 2004, the Financial AccountingStandards Board (“FASB”) issued SFAS No. 123 (revised 2004), *Share-Based Payments* (“SFAS 123R”), which is a revision ofSFAS No. 123. SFAS 123R supersedes APB 25. SFAS 123R requires allshare-based payments to employees, including grants of employee stock options,to be recognized in the income statement based on their fair values. Thedisclosure-only approach permitted by SFAS 123 and elected by the Company is nolonger an alternative. Accordingly, the adoption of SFAS 123R’s fair valuemethod may have a significant impact on the results of operations, although itwill have no impact on the Company’s overall financial position. The impact ofadoption of SFAS 123R cannot be predicted at this time because it will dependon levels of share-based payments granted in the future. However, had theCompany adopted SFAS 123R, the impact of that standard would have approximatedthe impact of SFAS 123 as described in the disclosure of pro forma net incomeand earnings per share above. The Company is required to adopt the provisionsof SFAS 123R effective January 1, 2006.

 

8

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* *

***6.******                                      ComprehensiveLoss***

 

Total comprehensive loss for the three and six monthperiods ended June 30, 2005 amounted to $307,000 and $505,000,respectively.  Comprehensive loss iscomprised of net loss plus the increase/decrease in currency translationadjustment.

 

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

 

Inventories are stated at the lower of cost ormarket using the first-in, first-out (FIFO) method and consist of the following(in thousands):

 

| ** **       | ** ** | **June 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|------------------|------------|-------------------------|------------|-----------------------------|------------|
| Raw materials    |       | $                       | 973        |                        | $          | 889 |   |
| Work in progress |       | 71                      |       | 130                         |       |
| Finished goods   |       | 102                     |       | 93                          |       |
|             |       | $                       | 1,146      |                        | $          | 1,112 |   |

 

At June 30, 2005 and December 31, 2004,inventories are stated net of a reserve of $505,000 and $528,000, respectively,for potentially obsolete inventory.

 

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

 

The Company records revenuefrom the sale of TMR kits and Optiwave 980 Systems at the time of shipment toEdwards.  TMR kit revenues include theamount invoiced to Edwards for kits shipped pursuant to purchase orders received,as well as an amortized portion of deferred revenue related to Edwards’ paymentof $4,533,333 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 (see Note 3).  The Company isamortizing this payment from Edwards into its Consolidated Statement ofOperations as revenue over a seven year period 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 mostappropriate amortization period based on a valuation model they used to assessthe economic fairness of the payment. Factors management considered in developingthis valuation model included the estimated foregone revenues over a seven yearperiod resulting from the reduction in the prospective purchase price payableto the Company by Edwards, a discount rate deemed appropriate to thetransaction and an estimate of the remaining economic useful life of thecurrent TMR kit design, without any benefit being given to potential futureproduct improvements the Company may make. For the three and six months ended June 30,2005, the Company has recorded amortization of $98,000 and $174,000,respectively.

 

TMR lasers are billed toEdwards in accordance with purchase orders that the Company receives. InvoicedTMR lasers are recorded as other current assets and deferred revenue on theCompany’s Consolidated Balance Sheet until such time as the laser is shipped toa hospital, at which time the Company records revenue and cost of revenue.

 

Under the terms of theEdwards TMR distribution agreement, once Edwards has recovered a prescribedamount of revenue from a hospital for the use or purchase of a TMR laser,

 

9

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anyadditional revenues earned by Edwards are shared with the Company pursuant to aformula established in the distribution agreement. The Company only records itsshare of such additional revenue, if any, at the time the revenue is earned.

 

TheCompany records revenue from the sale of TMR kits and TMR lasers tointernational distributors or hospitals at the time of shipment.

 

Revenues from service andmaintenance contracts are recognized ratably over the life of the contract.

 

Installation revenuesrelated to a TMR laser transaction are recorded as a component of service feeswhen the laser is installed.

 

# ***9.****                                     **Warranty and PreventativeMaintenance Costs*

# ** **

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

 

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

 

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

 
| ** **                                                 | ** ** | **Six Months Ended  June 30,** | ** ** |
|------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                 | ** ** | **2005**                            | ** ** | **2004** | ** ** |
| Balance,  beginning of period                              |       | $                                   | 60         |   | $ | 60 |   |
| Payments made                                              |       | —                              |       | — |   |
| Change in  liability for warranties issued during the year |       | —                              |       | 7 |   |
| Change in  liability for preexisting warranties            |       | —                              |       | (7 | ) |
|                                                       |       |                                |       |   |   |
| Balance, end of  period                                    |       | $                                   | 60         |   | $ | 60 |   |

 

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

 

This quarterly report (including certain informationincorporated herein by reference) contains forward-looking statements withinthe meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21Eof the Securities Exchange Act of 1934, as amended (the “Exchange Act”).Statements containing terms such as “believes”, “plans”, “expects”, “anticipates”,“intends”, “estimates” and similar expressions reflect uncertainty and areforward-looking statements. Forward-looking statements are based on currentplans and expectations and involve known and unknown important risks anduncertainties that could cause actual results to

 

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differ materially fromthose described in the forward-looking statements. Such important factors anduncertainties include, but are not limited to, those set forth below under theheading “Certain Factors that May Affect our Future Results” and elsewherein this quarterly report.

 

# **Overview**

# ** **

We are a medical devicecompany specializing in innovative technologies for the cardiac and vascularmarkets.  We currently manufacture lasersfor use in the treatment of cardiovascular disease.  Our Heart Laser Systems are used to treatpatients with severe angina and the Optiwave 980 System, when commerciallyintroduced, is expected to be used to ablate cardiac tissue as a means to treatcertain heart arrhythmias.

 

Edwards is our exclusiveworldwide distributor for all surgical cardiac ablation products and, in theUnited States, acts as our exclusive distributor for TMR products. Edwards isour largest customer, accounting for approximately 91% and 90%, respectively,of our total sales for the three and six months ended June 30, 2005 and88% in the year ended December 31, 2004. We expect this sales trend tocontinue for the foreseeable future.

 

Approximately 85% and 86%,respectively, of our revenues in the three and six months ended June 30,2005 and 90% in the year ended December 31, 2004, came from the sale andservice of TMR lasers and related disposable kits. Although not a directmeasure, we believe a leading indicator of the adoption rate of TMR as atreatment for severe angina is TMR kit shipments to hospitals.  We remain largely dependent on the success ofEdwards’ sales and marketing efforts to increase our installed base of TMRlasers and increase TMR procedure volumes and revenues.

 

Our management reviews anumber of key performance indicators to assist them in determining how toallocate resources and run our day to day operations. These indicators include (1) actualprior quarterly sales trends, (2) projected TMR laser and kit sales forthe next four quarters, as provided by Edwards in a rolling twelve month salesforecast, (3) research and development progress as measured againstinternal project plan objectives, (4) budget to actual financialexpenditure results, (5) inventory levels (both our own and Edwards’) and (6) shortterm and long term projected cash flows of the business.

 

**Application of Critical AccountingPolicies and Estimates**

 

This management’s discussion and analysis of financialcondition and results of operations is based on our condensed consolidatedfinancial statements, which have been prepared in accordance with accountingprinciples generally accepted in the United States.  Our significant accounting policies are morefully described in Note 2 of the Notes to Consolidated Financial Statements aswell as in “Item 7 - Management’s Discussion and Analysis of FinancialCondition and Results of Operations – Critical Accounting Policies andEstimates”, each as contained in our Annual Report on Form 10-K for theyear ended December 31, 2004.  Nosignificant changes were made to those policies during the three months ended June 30,2005.

 

# ***Inventories***

# ** **

Inventories are stated atthe lower of cost or market value.  Aspecific obsolescence allowance is provided for slow moving, excess andobsolete inventory based on our best estimate

 

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ofthe net realizable value of inventory on hand taking into consideration factorssuch as (1) actual trailing twelve month sales, (2) expected futureproduct line demand, based in part on sales forecast input received fromEdwards, and (3) service part stocking levels which, in management’s bestjudgment, are advisable to maintain in order to meet warranty, service contractand time and material spare part demands. Historically, we have found our reserves to be adequate.

 

# ***Allowance for Doubtful Accounts***

# ** **

For our accounts receivable,we continuously monitor collections from customers, our principal customerbeing Edwards, and we maintain a provision for estimated credit losses basedupon historical experience and any specific customer collection issues that wehave identified.  Historically, we havenot experienced 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 Preventative Maintenance Costs***

# ** **

We warranty our productsagainst manufacturing defects under normal use and service during the warrantyperiod.  We obtain similar warrantiesfrom a majority of our suppliers, including those who supply critical HeartLaser System components.  In addition,under the terms of our TMR distribution agreement with Edwards, we are able tobill Edwards for actual warranty costs, including preventative maintenance services,up to a specified amount during the warranty period.

 

We evaluate the estimatedfuture unrecoverable costs of warranty and preventative maintenance servicesfor our installed base of lasers on a quarterly basis and adjust our warrantyreserve accordingly.  We consider allavailable evidence, including historical experience and information obtainedfrom supplier audits.

 

## ***Revenue Recognition***

## ** **

We record revenue from thesale of TMR kits and Optiwave 980 Systems at the time of shipment toEdwards.  TMR kit revenues include theamount invoiced to Edwards for kits shipped pursuant to purchase ordersreceived, as well as an amortized portion of deferred revenue related toEdwards’ payment to us of $4,533,333 in February 2004 in exchange for areduction in the prospective purchase price we receive from Edwards upon a saleof the kits. We are amortizing this payment from Edwards into our ConsolidatedStatement of Operations as revenue over a seven year period under theunits-of-revenue method as prescribed by Emerging Issues Task Force (EITF) 88-18,*Sales of Future Revenue*. We determinedthat a seven year timeframe was the most appropriate amortization period basedon a valuation model we used to assess the economic fairness of the payment.Factors we considered in developing this valuation model included the estimatedforegone revenues over a seven year period resulting from the reduction in theprospective purchase price payable to us by Edwards, a discount rate deemedappropriate to the transaction and an estimate of the remaining economic usefullife of the current TMR kit design, without any benefit being given topotential future product improvements we may make. For the three and six monthsended June 30, 2005, we recorded amortization of $98,000 and $174,000,respectively.

 

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TMR lasers are billed toEdwards in accordance with purchase orders that we receive. Invoiced TMR lasersare recorded as other current assets and deferred revenue on our consolidatedbalance sheet until such time as the laser is shipped to a hospital, at whichtime we record revenue and cost of revenue.

 

Under the terms of theEdwards TMR distribution agreement, once Edwards has recovered a prescribedamount of revenue from a hospital for the use or purchase of a TMR laser, anyadditional revenues earned by Edwards are shared with us pursuant to a formulaestablished in the distribution agreement. We only record our share of suchadditional revenue, if any, at the time the revenue is earned.

 

We recordrevenue from the sale of TMR kits and TMR lasers to international distributorsor hospitals at the time of shipment.

 

Revenues from service andmaintenance contracts are recognized ratably over the life of the contract.

 

Installation revenuesrelated to a TMR laser transaction are recorded as a component of service feeswhen the laser is installed.

 

**Results of Operations**

 

Results for the three and six months ended June 30,2005 and 2004 and the related percent of revenues were as follows:

 
| ** **                                  | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|---------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                  | ** ** | **2005**                              | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                  | ** ** | **$**                                 | ** ** | **%**                               | ** ** | **$** | ** ** | **%** | ** ** | **$** | ** ** | **%** | ** ** | **$** | ** ** | **%** | ** ** |
| ** **                                  | ** ** | **(dollars  in thousands)**           | ** ** |
|                                        |       |                                  |       |                                |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total revenues                              |       | 1,982                                 |       | 100                                 |       | 1,796 |   | 100 |   | 3,925 |   | 100 |   | 3,705 |   | 100 |   |
| Total cost of  revenues                     |       | 790                                   |       | 40                                  |       | 747 |   | 42 |   | 1,518 |   | 39 |   | 1,513 |   | 41 |   |
| Gross profit                                |       | 1,192                                 |       | 60                                  |       | 1,049 |   | 58 |   | 2,407 |   | 61 |   | 2,192 |   | 59 |   |
| Selling,  general & administrative |       | 897                                   |       | 45                                  |       | 866 |   | 48 |   | 1,777 |   | 45 |   | 1,856 |   | 50 |   |
| Research &  development            |       | 649                                   |       | 33                                  |       | 516 |   | 29 |   | 1,220 |   | 31 |   | 1,045 |   | 28 |   |
| Loss from  operations                       |       | (354                                  | )          | (18                                 | )          | (333 | ) | (19 | ) | (590 | ) | (15 | ) | (709 | ) | (19 | ) |
| Other income                                |       | 64                                    |       | 3                                   |       | 82 |   | 5 |   | 116 |   | 3 |   | 108 |   | 3 |   |
| Net loss                                    |       | (290                                  | )          | (15                                 | )          | (251 | ) | (14 | ) | (474 | ) | (12 | ) | (601 | ) | (16 | ) |

 

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| ** **                                           | ** ** | **Three Months Ended**      | ** ** | ** **              | ** ** | **Six Months Ended** | ** ** | ** **              | ** ** |
|------------------------------------------------------|------------|-----------------------------|------------|-------------------------|------------|----------------------|------------|-------------------------|------------|
| ** **                                           | ** ** | **June 30,**           | ** ** | **Increase (decrease)** | ** ** | **June 30,**    | ** ** | **Increase (decrease)** | ** ** |
| ** **                                           | ** ** | **2005**                    | ** ** | **2004**                | ** ** | **over 2004**        | ** ** | **2005**                | ** ** | **2004** | ** ** | **over 2004** | ** ** |
| ** **                                           | ** ** | **$**                       | ** ** | **$**                   | ** ** | **$**                | ** ** | **%**                   | ** ** | **$** | ** ** | **$** | ** ** | **$** | ** ** | **%** | ** ** |
| ** **                                           | ** ** | **(dollars  in thousands)** | ** ** |
|                                                 |       |                        |       |                    |       |                 |       |                    |       |   |   |   |   |   |   |   |   |
| Product sales                                        |       | 1,567                       |       | 1,354                   |       | 213                  |       | 16                      |       | 3,125 |   | 2,885 |   | 240 |   | 8 |   |
| Service fees                                         |       | 415                         |       | 442                     |       | (27                  | )          | (6                      | )          | 800 |   | 820 |   | (20 | ) | (2 | ) |
| Total revenues                                       |       | 1,982                       |       | 1,796                   |       | 186                  |       | 10                      |       | 3,925 |   | 3,705 |   | 220 |   | 6 |   |
| Product cost of  sales                               |       | 600                         |       | 575                     |       | 25                   |       | 4                       |       | 1,152 |   | 1,165 |   | (13 | ) | (1 | ) |
| Service fees  cost of sales                          |       | 190                         |       | 172                     |       | 18                   |       | 10                      |       | 366 |   | 348 |   | 18 |   | 5 |   |
| Total cost of  revenues                              |       | 790                         |       | 747                     |       | 43                   |       | 6                       |       | 1,518 |   | 1,513 |   | 5 |   | — |   |
| Gross profit                                         |       | 1,192                       |       | 1,049                   |       | 143                  |       | 14                      |       | 2,407 |   | 2,192 |   | 215 |   | 10 |   |
| Selling,  general & administrative expenses |       | 897                         |       | 866                     |       | 31                   |       | 4                       |       | 1,777 |   | 1,856 |   | (79 | ) | (4 | ) |
| Research &  development expenses            |       | 649                         |       | 516                     |       | 133                  |       | 26                      |       | 1,220 |   | 1,045 |   | 175 |   | 17 |   |
| Total operating  expenses                            |       | 1,546                       |       | 1,382                   |       | 164                  |       | 12                      |       | 2,997 |   | 2,901 |   | 96 |   | 3 |   |
| Other income                                         |       | 64                          |       | 82                      |       | (18                  | )          | (22                     | )          | 116 |   | 108 |   | 8 |   | 7 |   |
| Net loss                                             |       | (290                        | )          | (251                    | )          | (39                  | )          | (16                     | )          | (474 | ) | (601 | ) | 127 |   | 21 |   |

 

***Product Sales***

 

TMR laser revenues, thelargest component of product sales in the three and six months ended June 30,2005, increased by $3,000, and decreased by $278,000, or 17%, respectively, ascompared to the three and six months ended June 30, 2004.

 

In the three months ended June 30,2005 the $3,000 increase in TMR laser revenues is primarily a result of ahigher average domestic selling price on TMR laser sales and increased revenuesharing earned under the TMR distribution agreement offset by a decrease in thenumber of new TMR laser units sold by Edwards in the second quarter of 2005(four) compared to the second quarter of 2004 (six).

 

In the six months ended June 30,2005, the $278,000 decline in TMR laser revenues is primarily a result of adecrease in the number of new TMR laser units sold by Edwards in the six monthsended June 30, 2005 (eight) compared to the six months ended June 30,2004 (twelve) and decreased revenue sharing earned under the TMR distributionagreement. These decreases were partly offset by a higher average domesticselling price on TMR laser sales in the 2005 period.

 

Disposable TMR kit revenues,the second largest component of product sales, increased by $44,000, or 8%, and$221,000, or 23%, respectively, in the three and six months ended June 30,2005 as compared to the three and six months ended June 30, 2004.  The increase in the three months ended June 30,2005 is primarily related to a $30,000, or 6%, increase in domestic disposablerevenue.  This $30,000 increase resultedfrom an increase in deferred revenue amortization related to the $4,533,333payment by Edwards offset slightly by a lower volume of

 

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kitshipments to Edwards. International disposable revenue was $14,000 in the threemonths ended June 30, 2005 as compared to $0 in the three months ended June 30,2004.

 

The increase in disposableTMR kit revenues in the six months ended June 30, 2005 is primarilyrelated to a $185,000, or 20%, increase in domestic disposable revenue.  This $185,000 increase resulted from a highervolume of kit shipments to Edwards as well as an increase in deferred revenueamortization related to the $4,533,333 payment by Edwards. Internationaldisposable revenue increased by $36,000, or 65%, due to a 20% increase in thenumber of TMR kits shipped to international customers in the six months ended June 30,2005 as compared to the six months ended June 30, 2004.

 

Optiwave 980 System revenuesfrom Edwards increased $192,000 and $345,000, respectively, in the three andsix months ended June 30, 2005 as compared to the three and six monthsended June 30, 2004 when we had no such sales.  The Optiwave 980 System revenues wehave recognized to date consist of laser power sources sold to Edwards for usein marketing evaluations that they are conducting. We do not expect anyadditional significant revenues from Optiwave 980 System sales until such timethat Edwards successfully completes its marketing evaluations and commerciallylaunches the system into the market.

 

We must successfully increase our disposablemanufacturing capacity to meet Edwards’ sales demand once they commerciallylaunch the Optiwave 980 System. We believe it will take us approximately sixmonths to sufficiently increase our disposable manufacturing capability if andwhen Edwards provides us with a sales forecast and, therefore, we do not expectat this time to generate any revenues from the sale of Optiwave disposables in2005.

 

Other product sales,relating to sales of new and refurbished surgical tubes, decreased $26,000, or19%, and $48,000, or 19%, respectively, in the three and six months ended June 30,2005 as compared to the three and six months ended June 30, 2004.

 

***Service Fee Revenues***

 

Service fee revenues decreased $27,000, or 6%, and$20,000, or 2%, in the three and six months ended June 30, 2005,respectively, as compared to the three and six months ended June 30,2004.  International service fee revenuesdecreased $79,000, or 59%, and $30,000, or 19%, in the three and six monthsended June 30, 2005, respectively, as compared to the three and six monthsended June 30, 2004.  This decreasewas offset in part by an increase in domestic service fee revenues of $52,000,or 17% and $10,000, or 2%, respectively, in the three and six months ended June 30,2005 as compared to the three and six months ended June 30, 2004 due toincreased billings to Edwards for service related calls.

 

***Gross Profit***

 

Total gross profit was$1,192,000, or 60%, and $2,407,000, or 61%, respectively, of total revenues forthe three and six months ended June 30, 2005 as compared with gross profitof $ 1,049,000, or 58%, and $2,192,000, or 59%, of total revenues, for thethree and six months ended June 30, 2004. The increase in gross profit dollars in the three months ended June 30,2005 as compared to the three months ended June 30, 2004 is due to (1) anincrease in additional revenue sharing earned under the TMR distributionagreement, (2) higher disposable TMR revenues, (3) new product salesof Optiwave 980 Systems and (4) a higher average domestic 

 

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sellingprice on TMR laser sales.  Theseincreases were offset in part by (1) a decrease in the number of new TMRlasers sold, (2) higher unabsorbed period overhead expenditures, (3) adecrease in other product sales relating to sales of new and refurbishedsurgical tubes and (4) a decrease in service related revenues.

 

The increase in gross profitdollars in the six months ended June 30, 2005 as compared to the sixmonths ended June 30, 2004 is due to (1) higher disposable TMRrevenues, (2) new product sales of Optiwave 980 Systems and (3) ahigher average domestic selling price on TMR laser sales. These increases wereoffset in part by (1) a decrease in the number of new TMR lasers sold, (2) higherunabsorbed period overhead expenditures (3) a decrease in other productsales relating to sales of new and refurbished surgical tubes and (4) adecrease in service related revenues.

 

***Selling, General and AdministrativeExpenses***

 

Selling, general andadministrative expenses increased 4% and decreased 4%, respectively, in thethree and six months ended June 30, 2005 as compared to the three and sixmonths ended June 30, 2004. In the three month period, the increase isprimarily a result of increased expenditures related to salary and relatedfringe benefits and bad debt expenses offset in part by lower legal andadministrative fees.  In the six monthperiod, the decrease is related to lower legal and administrative fees and baddebt expenses offset in part by increased salary and related fringe benefitsand insurance expenditures.

 

***Research and Development Expenses***

 

A major component of ourresearch and development expenses was salaries and associated fringe benefits,which accounted for 35% and 37% of expenditures, respectively, in the threemonths ended June 30, 2005 and 2004 and 47% and 42% of expenditures,respectively, in the six months ended June 30, 2005 and 2004.

 

The increased expendituresin the three and six months ended June 30, 2005 as compared to the threeand six months ended June 30, 2004 were incurred in connection withproduct development work on an additional internal research and developmentinitiative.

 

We expect to continue toincur significant new research and development expenditures in 2005 in pursuitof our business strategy to broaden and diversify our product portfolio.  In particular, we expect our annual 2005research and development expenditures to increase in the aggregateapproximately $600,000 compared to 2004 as a result of expected continued workon the Optiwave 980 System and product development work on an additionalinternal research and development initiative.

 

***Other Income***

 

The largest component ofother income is interest income earned on our cash and short-term investments.Interest income increased by $34,000 and $60,000, respectively, in the threeand six months ended June 30, 2005 compared to the three and six monthsended June 30, 2004 due to higher average interest earned on our cash andshort-term investments. A second component of other income decreased $52,000 inboth the three and six months ended June 30, 2005 as a result ofnon-recurring proceeds from an insurance settlement received in the second

 

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quarterof 2004.

 

***Net Loss***

 

The net loss in the threemonths ended June 30, 2005 and 2004 was $290,000 and $251,000,respectively. This increase in the net loss resulted primarily from higheroperating expenses offset in part by higher gross margin dollarsgenerated.  The net loss in the sixmonths ended June 30, 2005 and 2004 was $474,000 and $601,000,respectively.  This decrease in the netloss resulted primarily from higher gross margin dollars generated offsetslightly by higher operating expenses.

 

We expect to incur a netloss in the twelve months ended December 31, 2005, primarily as a resultof our planned increased investments in research and development expenses, asdiscussed above.

 

***Kit Shipments***

 

We view disposable kitshipments to end users as an important metric in evaluating our business.  We believe kit shipments are a reasonableindicator for the adoption of TMR as a therapy in the marketplace.  Disposable kit shipments to end users duringthe three and six months ended June 30, 2005 and June 30, 2004 wereas follows:

 
| ** **    | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|---------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **    | ** ** | **2005**                             | ** ** | **2004**                           | ** ** | **% Increase  over 2004** | ** ** | **2005** | ** ** | **2004** | ** ** | **% Increase  over 2004** | ** ** |
|          |       |                                 |       |                               |       |   |   |   |   |   |   |   |   |
| Domestic      |       | 566                                  |       | 502                                |       | 13 |   | 1,005 |   | 884 |   | 14 |   |
| International |       | 5                                    |       | 1                                  |       | 400 |   | 55 |   | 46 |   | 20 |   |
| Total         |       | 571                                  |       | 503                                |       | 14 |   | 1,060 |   | 930 |   | 14 |   |

 

**Liquidity and Capital Resources**

 

At June 30, 2005, we had cash, cash equivalentsand short-term investments of $9,545,000. We have no debt obligations.

 

During the six-month period ended June 30, 2005,we recorded a net loss of $474,000.  Inaddition, we had net unfavorable working capital changes which resulted in netcash used for operating activities of approximately $60,000. Cash used ininvesting activities was approximately $6,930,000, consisting of the purchaseof short-term investments of $6,900,000 and $30,000 of investments inequipment.  We believe that our existingcash resources will meet our working capital requirements through the next 12months.

 

We are largely dependent onthe success of Edwards’ sales and marketing efforts in the U.S. to continue toincrease the installed base of HL2 lasers and substantially increase TMRprocedural volumes and revenues. Should the installed base of HL2 lasers or TMRprocedural volume not increase sufficiently, our liquidity and capitalresources will be negatively impacted. Additionally, other unanticipated decreases in operating revenues orincreases in expenses or further changes or delays in third-party reimbursementto healthcare providers using our products

 

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mayadversely impact our cash position and require further cost reductions or theneed to obtain additional financing.  Itis not certain that we, working with Edwards and our internationaldistributors, will be successful in achieving broad commercial acceptance ofthe Heart Laser Systems, or that we will be able to operate profitably in thefuture on a consistent basis, if at all.

 

Some hospital customersprefer to acquire the Heart Laser Systems on a usage basis rather than as acapital equipment purchase.  We believethis is the result of limitations many hospitals currently have on acquiringexpensive capital equipment as well as competitive pressures in themarketplace.  A usage business model willresult in a longer recovery period for Edwards to recoup its investment inlasers it purchases from us.  Thisresults in (1) a delay in our ability to receive additional sharedrevenue, if any, that we otherwise are entitled to receive under the terms ofour distribution agreement with Edwards (see “Critical Accounting Policies andEstimates – Revenue Recognition”) and (2) a delay in the purchase of newlasers by Edwards if its installed base of lasers placed under usage contractsare under-performing and it chooses to re-deploy these lasers to other hospitalsites in lieu of purchasing a new laser from us.  Our cash position and our need for additionalfinancing to fund operations will be dependent in part upon the number ofhospitals that acquire Heart Laser Systems from Edwards on a usage basis andthe number and frequency of TMR procedures performed by these hospitals.

 

Furthermore, we haveundertaken a new business strategy that involves broadening and diversifyingour product portfolio beyond our current TMR offerings, by developing oracquiring new and innovative medical devices to address cardiac and vascularrelated markets. We believe this strategy will result in our incurring lossesfor at least the next 12-24 months as we increase our investments in bothmanufacturing and research and development staff necessary to pursue these newstrategic initiatives, including, the Optiwave 980 System and an additional internalresearch and development initiative. We cannot be certain that we will besuccessful in implementing our new business strategy or that future sales, ifany, from these planned new products will recover the investments we plan tomake. If we are unsuccessful in implementing our new business strategy, or ifthe diversification 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.

 

There can be no assurancethat, should we require additional financing, such financing will be availableon terms and conditions acceptable to us. Should additional financing not be available on terms and conditionsacceptable to us, additional actions may be required that could adverselyimpact our ability to continue to realize assets and satisfy liabilities in thenormal course of business.  Theconsolidated financial statements set forth in this report do not include anyadjustments to reflect the possible future effects of these uncertainties.

 

**Off-Balance Sheet Arrangements**

 

None.

 

## **Certain Factors that May Affect our Future Results**

## ** **

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

 

18

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***We expect to incur significant operatinglosses in the near future***

 

We incurred a net loss inthe quarter ended June 30, 2005.  Weexpect to continue to incur net losses for at least the next 12-24 months as weincrease our spending in the areas of manufacturing and research anddevelopment for the Optiwave 980 System and other strategic research anddevelopment programs. Moreover, as we continue to pursue our new businessstrategy of acquiring or developing new medical devices to address cardiac andvascular related markets, we may continue to incur expenses that exceed therevenues we generate.  We cannot provideany assurance that we will be successful with our new business strategy or thatwe will ever return to profitability.

 

***Our company is currently dependent on oneprincipal product line to generate revenues***

 

We currently market oneproduct line, which consists of two patented high-powered carbon dioxide lasersand related TMR disposable kits known as the Heart Laser Systems, which accountfor the majority of our total revenue. Approximately 85% and 86%, respectively, of our revenues in the threeand six months ended June 30, 2005 and 90% in the year ended December 31,2004, 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.

 

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

 

Pursuant to the terms of ourTMR distribution agreement with Edwards, Edwards is our exclusive distributorfor our HL2 TMR laser and TMR kits in the United States.  In addition, pursuant to the terms of our newdistribution agreement with Edwards for the Optiwave 980 System (as well as anyother additional surgical products that we may develop for the treatment ofatrial fibrillation, or AF), Edwards is our exclusive worldwide distributor ofthose products.  As a result of theseexclusive distribution arrangements, Edwards accounted for 91% and 90% of ourtotal revenues in the three and six months ended June 30, 2005,respectively, and 88% in the year ended December 31, 2004 and we expectEdwards to account for the significant majority of our revenue in thefuture.  If our relationship with Edwardsdoes not progress as anticipated, or if Edwards’ sales and marketing strategiesfail to generate sales of our products in the future, our revenue will decreasesignificantly and our business, financial condition and results of operationswill be seriously harmed.

 

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

 

Some of the components forour Heart Laser Systems, most notably the power supply and certain optics andfabricated parts for the HL2, and certain components for the Optiwave 980System, are only available from one supplier, and we have no assurance that wewill be able to source any of our sole-sourced components from additionalsuppliers.  We are dependent upon oursole suppliers to perform their obligations in a timely manner.  In the past, we have experienced delays inproduct delivery from our sole suppliers and, because we do not have analternative 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

 

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year.  Our low-quantity needs may not generatesubstantial revenue for our suppliers. Therefore, it may be difficult for us to continue our relationships withour current suppliers or establish relationships with additional suppliers oncommercially reasonable terms, if at all, and such difficulties may seriouslyharm our business, financial condition and results of operations.

 

***Edwards must successfully complete theirmarketing evaluations of the Optiwave 980 System before they commit to launchthe product***

 

Edwards is currently conducting marketingevaluations of the Optiwave 980 System at hospitals across the country. Edwardsmust complete these marketing evaluations and judge them to be successfulbefore they will commit to launch the product into the market. Although webelieve the evaluations of the product to date have been positive, we cannotassure you that Edwards will successfully complete these marketing evaluationsof the Optiwave 980 System or that they will not decide to cancel the programin the future. Should Edwards decide for whatever reason not to market theOptiwave 980 System, our revenue growth prospects, financial condition andresults of operations will be materially and adversely affected.

 

***We must transition manufacturing of theOptiwave 980 disposable handpieces from Edwards and be able to manufacture themin required volumes at commercially reasonable costs***

 

AssumingEdwards successfully completes their marketing evaluations of the Optiwave 980System, we must successfully transition production of the Optiwave 980disposable handpieces to our leased manufacturing space in Billerica,Massachusetts. We must hire new skilled manufacturing employees and we mustdevelop and validate our manufacturing processes with respect to building thesedisposable handpieces.  We expect toincur expenses to outfit our manufacturing space with the necessary productionand test equipment and to train our employees on how to build the product. Wewill need to be able to manufacture these highly specialized disposablehandpieces for which we have no comparable prior experience producing at anyvolume.  Until such time as we becomemore proficient in these manufacturing methods, if ever, we may encounterproblems, including those related to:

 

•                  production yields;

•                  quality control;

•                  training;

•                  shortages of qualifiedpersonnel; and

•                  potential capacityconstraints.

 

Suchproblems could severely affect our ability to adequately scale up productionand meet demand for our products on a timely basis, which could harm ourbusiness, financial condition and results of operations.

 

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

 

Ourability to operate our business successfully depends in significant part uponthe retention and motivation of certain key technical, regulatory, productionand managerial personnel and consultants and our ongoing ability to hire andretain additional qualified personnel in these areas. Competition for suchpersonnel is intense, particularly in the Greater Boston area. We cannot

 

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be certain that we will be able to attract such personneland the loss of any of our current key employees or consultants could have asignificant adverse impact on our business.

 

***Our company may be unable to raise neededfunds***

 

As of June 30, 2005, wehad cash, cash equivalents and short-term investments totaling $9,545,000.Based on our current operating plan, we anticipate that our existing capitalresources should be sufficient to meet our working capital requirements for atleast the next 12 months.  However, ifour business does not progress in accordance with our current business plan, wemay need to raise additional funds in the future.  We may not be able to raise additionalcapital upon satisfactory terms, or at all, and our business, financialcondition and results of 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 compete effectively, ourcurrent and future products need to gain commercial acceptance***

 

TMR and surgical ablationfor cardiac arrhythmias are still both emerging technologies.  Our current and planned future products maynever achieve widespread commercial acceptance. To be successful, we need to:

 

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

 

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

 

•                  have more heart surgeons trained to performTMR procedures using the Heart Laser Systems and surgical tissue ablationprocedures using the Optiwave 980 System; and

 

•                  maintain and expand third-party reimbursementfor the TMR procedure.

 

To date, only a limitednumber of heart surgeons have been trained in the use of TMR using the HeartLaser Systems and cardiac tissue ablation procedures using the Optiwave 980System.  We are dependent on Edwards toexpand related marketing and training efforts in the U.S. for the use of ourproducts.

 

Although the Heart LaserSystems have received FDA approval and the CE Mark, they 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.

 

In addition, although theOptiwave 980 System has received FDA clearance, it has not yet secured the CEMark and it is therefore not yet ready for worldwide commercialization. If weare

 

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unableto maintain regulatory clearances, secure the CE Mark for the Optiwave 980System or achieve widespread commercial acceptance of the Heart Laser Systemsor the Optiwave 980 System, our business, financial condition and results ofoperations will be materially and adversely affected.

 

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

 

Our primary TMR competitor,CardioGenesis, is attempting to obtain FDA approval to market their “percutaneous”method of performing myocardial revascularization, previously known as PMR, andrecently rebranded as PMC (percutaneous myocardial channeling), which wouldprovide a less invasive method of creating channels in the heart.  If PMCcan be shown to be safe and effective and is approved by the FDA, it wouldeliminate the need in certain patients to make an incision in the chest,reducing costs and speeding recovery.  Itis unclear what impact, if any, an approval of a PMC device would have on thefuture adoption rate for TMR procedures. If PMC is approved, it could erode the potential TMR market which wouldhave a material adverse effect on our business, financial condition and resultsof operations.

 

***Rapid technological changes in our industrycould make our products obsolete***

 

Our industry ischaracterized by rapid technological change and intense competition.  New technologies and products and newindustry standards will develop at a rapid pace, which could make our currentand future planned products obsolete. The advent of new devices and proceduresand advances in new drugs and genetic engineering are especially concerningcompetitive threats.  Our future successwill depend upon our ability to develop and introduce product enhancements toaddress the needs of our customers. Material delays in introducing product enhancements may cause customersto forego purchases of our products and purchase those of our competitors.

 

Many potential competitorshave substantially greater financial resources and are in a better financialposition to exploit marketing and research and development opportunities.  In addition, we are aware that othercompanies are developing or already have developed proprietary systems for thetreatment of cardiac arrhythmias, and specifically AF, that may be safer,clinically more effective, easier and more cost effective to use and, in thecase of percutaneous devices, less invasive than the system we are developing.

 

***We must receive and maintain governmentclearances or approvals in order to market our products***

 

Our products and ourmanufacturing activities are subject to extensive, rigorous and changingfederal and state regulation in the U.S. and to similar regulatory requirementsin other major international markets, including the European Union andJapan.  These regulations and regulatoryrequirements are broad in scope and govern, among other things:

 

•                  product design and development;

•                  product testing;

•                  product labeling;

•                  product storage;

•                  premarket clearance and approval;

 

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•                  advertising and promotion; and

•                  product sales and distribution.

 

Furthermore, regulatoryauthorities subject a marketed product, its manufacturer and the manufacturingfacilities to continual review and periodic inspections.  We are subject to ongoing FDA requirements,including required submissions of safety and other post-market information andreports, registration requirements, Quality Systems regulations, andrecordkeeping requirements. The FDA’s Quality Systems regulations includerequirements relating to quality control and quality assurance, as well as the correspondingmaintenance of records and documentation. Edwards, our distributor, depending on its activities, is also subjectto certain requirements under the Federal Food, Drug, and Cosmetic Act and theregulations promulgated thereunder, and state laws and registrationrequirements covering the distribution of our products. Regulatory agencies maychange existing requirements or adopt new requirements or policies that couldaffect our regulatory 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.

 

Later discovery ofpreviously unknown problems with our products, manufacturing processes, or ourfailure to comply with applicable regulatory requirements may result inenforcement actions by the FDA and other international regulatory authorities,including, but not limited to:

 

•                  warning letters;

•                  patient or physician notification;

•                  restrictions on our products or manufacturingprocesses;

•                  voluntary or mandatory recalls;

•                  product seizures;

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

•                  refusal to permit the import or export of ourproducts;

•                  fines;

•                  injunctions;

•                  suspension or withdrawal of marketingapprovals or clearances; and

•                  civil and criminal penalties.

 

Should any of theseenforcement actions occur, our business, financial condition and results ofoperations could be materially and adversely affected.

 

To date, we have receivedthe following regulatory approvals for our products:

 

***Heart Laser Systems***

 

*United States —*We received FDA approval to market the HL1 Heart Laser System in August 1998and the HL2 Heart Laser System in January 2001.  However, although we have received FDAapproval, the FDA:

 

•                  has restricted the use of the Heart LaserSystems by not allowing us to market these products to treat patients whose conditionis amenable to conventional treatments,

 

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such as heart bypasssurgery, stenting and angioplasty; and

 

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

 

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

 

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

 

•                  France has prohibited, and other EuropeanUnion countries could prohibit or restrict, use of the Heart Laser Systems.

 

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

 

Prior to marketing the HeartLaser Systems in Japan, we must receive approval from the Japanese government.This approval requires a clinical study in Japan with at least 60patients.  A study was completed in 1998with the HL1. Although the results of this study have been submitted to theJapanese government, we do not know whether the clinical study will besufficient or when, if ever, we will receive approval to sell the HL1 in Japan.In addition, it is unclear what impact the introduction of the HL2 into theU.S. and other international markets will have on our ability to market the HL1in Japan.

 

***Optiwave 980 System***

 

*United States —*The FDA has given clearance to the Optiwave 980System through the 510(k) premarket notification process with indications foruse as a surgical instrument for coagulation of soft tissue, including cardiactissue, in conjunction with or without endoscopic equipment in the contact ornon-contact mode in open or closed surgical procedures.

 

Although we have receivedclearance from the FDA only for the indications of use stated above,physicians, under the practice of medicine exception, may use the Optiwave 980System in any manner they choose in treating an individual patient, includingusing the device to treat patients with AF. However, neither we nor Edwards have conducted any clinical trialsdesigned to obtain data to submit to the FDA for the purpose of obtaining aspecific indication for use of the Optiwave 980 System that would allow us tomake claims or otherwise market this device for the treatment of AF. We areaware of several other companies that have announced their plans to conductclinical trials in support of a labeling claim that would allow them to markettheir devices for the treatment of AF if clearance is obtained from the FDA.

 

In the event these othercompetitors are successful in obtaining specific indications of use for theirdevices in the treatment of AF, the Optiwave 980 System may be at a competitivemarketing disadvantage until such time, if ever, that Edwards conducts aclinical trial, submits sufficient data to the FDA by means of a new 510(k) andobtains clearance to market the Optiwave 980 System for the treatment of AF. Wecannot provide any assurance that Edwards will ever conduct such a clinicaltrial or, if they do, that the data they obtain and submit to the FDA will besufficient for the FDA to expand the current indications of use and provideclearance for the Optiwave 980 System to be marketed for the treatment of AF.Also, we cannot assure you that even

 

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if such clearance isobtained, that it will be obtained in a timely enough fashion for our productsto remain competitive in the marketplace.

 

*Europe —*The Optiwave 980 System cannot be marketed in the EUuntil such time as it receives CE Mark approval. We need to complete and submitthe relevant technical documentation to the appropriate certifying body inorder to be able to apply the CE Mark that, if granted, will enable the productto be distributed in the EU.

 

***Changes in third party reimbursement forour TMR procedure could materially affect future demand for our TMR products***

 

Currently, Medicare and BlueCross Blue Shield provide coverage for TMR when it is performed as both a soletherapy treatment and when used as an adjunct to bypass surgery. Certain otherprivate insurance companies and health maintenance organizations also currentlyprovide reimbursement for these TMR procedures performed with our products, andphysician reimbursement codes have been established for both surgicalprocedures; however, we have limited data as to the breadth of this coveragefor the TMR procedures by private insurance companies and health maintenanceorganizations. Should third party insurance reimbursement for our TMR productsbe reduced or eliminated in the future, our business, financial condition andresults of operations would be materially and adversely affected.

 

In July 2004, CMSconvened the Medicare Coverage Advisory Committee (MCAC) to review and discussthe evidence and clinical data regarding TMR. The MCAC is an advisory panelconsisting of clinicians and other medical experts which CMS utilizes tosupplement their own internal expertise. Although the MCAC was not convened forthe purpose of making a reimbursement coverage recommendation, we believe CMShas reviewed the information presented at the MCAC meeting and has decided tocontinue existing Medicare coverage for TMR without any modification. Noassurance can be given that CMS will not choose to alter Medicare coverage inthe future, which could include (1) issuing new guidelines clarifying thepatient criteria for Medicare reimbursement, (2) reducing, modifying oreliminating the existing reimbursement coverage for TMR or (3) requestingadditional clinical studies to be performed.

 

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

 

In our industry, competitorsoften assert intellectual property infringement claims against oneanother.  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.

 

An adverse outcome in anylitigation or interference proceeding could subject us to significantliabilities to third parties and require us to cease using the technology thatis at issue or to license the technology from third parties.  In addition, a finding that any of ourintellectual property is invalid could allow our competitors to more easily andcost-effectively compete with us.  Thus,an unfavorable outcome in any patent litigation or interference proceedingcould have a material adverse effect on our business, financial condition orresults of operations.

 

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The cost to us of any patentlitigation or interference proceeding could be substantial.  Uncertainties resulting from the initiationand continuation of patent litigation or interference proceedings could have amaterial adverse effect on our ability to compete in the marketplace.  Patent litigation and interferenceproceedings may also absorb significant management time.

 

***We may be subject to product liabilitylawsuits; our insurance may not be sufficient to cover damages***

 

We may be subject to productliability claims.  Such claims may absorbsignificant management time and could degrade our reputation and themarketability of our products.  If productliability claims are made with respect to our products, we may need to recallthe implicated product which could have a material adverse effect on ourbusiness, financial condition and results of operations. In addition, althoughwe maintain product liability insurance, we cannot be sure that our insurancewill be adequate to cover potential product liability lawsuits. Our insuranceis expensive and in the future may not be available on acceptable terms, if atall. If a successful product liability claim or series of claims exceeds ourinsurance coverage, it could have a material adverse effect on our business,financial condition and results of operations.

 

***We are subject to risks associated withinternational operations***

 

A portion of our productsales are generated from operations 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 beno assurance that our international business will grow or that any of theforegoing risks will not result in a material adverse effect on our business orresults of operations.

 

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

 

Under Canadian law, you maynot be able to enforce a judgment issued by courts in the U.S. against us orour Canadian directors. The status of the law in Canada is unclear as towhether a U.S. citizen can enforce a judgment from a U.S. court in Canada forviolations of U.S. securities laws. A separate suit may need to be broughtdirectly in Canada.

 

***Our stock price has historically fluctuatedand may continue to fluctuate significantly in the future which may result inlosses for our investors***

 

Our stock price has been andmay continue to be volatile. Some of the factors that can affect our stockprice are:

 

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

•                  actual or anticipated quarterly increases ordecreases in revenue, gross margin or

 

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earnings, and changes in ourbusiness, operations or prospects;

•                  speculation or actual news announcements inthe media or industry trade journals about our company, our products, the TMRor cardiac ablation procedures or changes in reimbursement policies by Medicareand/or private insurance companies;

•                  announcements relating to strategicrelationships or mergers;

•                  conditions or trends in the medical deviceindustry;

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

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

 

***The market price of our stock may fall ifshareholders sell their stock***

 

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

 

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

 

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

 

**Item 3.****           Quantitative and Qualitative Disclosuresabout Market Risk**

 

A portion of our operations consists of salesactivities in foreign jurisdictions.  Wemanufacture our products exclusively in the U.S. and sell our products in theU.S. and abroad. As a result, our financial results could be affected byfactors such as changes in foreign currency exchange rates or weak economicconditions in the foreign markets in which we distribute our products.  Our operating results are exposed to changesin exchange rates between the U.S. dollar and foreign currencies, especiallythe Euro. When the U.S. dollar strengthens against the Euro, the value offoreign sales decreases. When the U.S. dollar weakens, the functional currencyamount of sales increases. No assurance can be given that foreign currencyfluctuations in the future will not adversely affect our business, financialcondition and results of operations, although at present we do not believe thatour exposure is significant as international sales represented only 4% and 6%of our consolidated sales in the three and six months ended June 30, 2005and 6% in the year ended December 31, 2004. We do not hedge any balancesheet exposures and intercompany balances against future movements in foreignexchange rates.

 

Our interest income andexpense are sensitive to changes in the general level of U.S. and foreigninterest rates. In this regard, changes in U.S. and foreign interest ratesaffect the interest earned on our cash and cash equivalents.  We do not believe that a 10% change to theapplicable interest rates would have a material impact on our future results ofoperations or cash flows.

 

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

## ** **

Ourmanagement, with the participation of our chief executive officer and chieffinancial officer, evaluated the effectiveness of our disclosure controls andprocedures as of June 30, 2005.

 

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The term “disclosure controls and procedures”, as defined in Rules 13a-15(e) and15d-15(e) under the Exchange Act, means controls and other procedures of acompany that are designed to ensure that information required to be disclosedby a company in the reports that it files or submits under the Exchange Act isrecorded, processed, summarized and reported within the time periods specifiedin the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controlsand procedures designed to ensure that information required to be disclosed bya company in the reports that it files or submits under the Exchange Act isaccumulated and communicated to the company’s management, including itsprincipal executive and principal financial officers, as appropriate to allowtimely decisions regarding required disclosure. Management recognizes that any controls and procedures, no matter how welldesigned and operated, can provide only reasonable assurance of achieving theirobjectives and management necessarily applies its judgment in evaluating thecost-benefit relationship of possible controls and procedures.  Based on the evaluation of our disclosurecontrols and procedures as of June 30, 2005, our chief executive officerand chief financial officer concluded that, as of such date, our disclosurecontrols and procedures were effective at the reasonable assurance level.

 

No change in our internalcontrol over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) underthe Exchange Act) occurred during the fiscal quarter ended June 30, 2005that has materially affected, or is reasonably likely to materially affect, ourinternal control over financial reporting.

 

**Part II.  Other Information**

 

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

 

On May 18, 2005, the Company held its 2005 AnnualMeeting of Shareholders (the “Shareholders Meeting”).  At the Shareholders Meeting, the followingmatters were approved by the vote specified below:

 

1.                                       KevinJ. Dunn and Brent Norton were elected as Class III directors and will holdoffice until the annual meeting of shareholders in 2008 or until theirsuccessors are duly elected and qualified. Mr. Dunn received 27,607,466 shares of common stock voting in favorof his election and 400,917 shares of common stock were withheld.  Dr. Norton received 27,617,675 shares ofcommon stock voting in favor of his election and 390,708 shares of common stockwere withheld.

 

2.                                       Toapprove the 2005 Stock Incentive Plan. The votes were cast as follows:  10,782,898 shares of common stock were votedfor the Plan, 1,716,366 shares of common stock were voted against the Plan,183,939 shares of common stock abstained from the vote and 15,325,180 shares ofcommon stock were broker non-votes.

 

3.                                       Theratification of the appointment of Vitale, Caturano & Co., Ltd. as theCompany’s independent registered public accounting firm for the year ending December 31,2005 was approved.  The votes were castas follows: 27,803,348 shares of common stock were voted for the ratification,142,949 shares of common stock were voted against the ratification and 62,086shares of common stock abstained from the vote.

 

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**Item 6.****           Exhibits**

 
| 10.1   | 2005 Stock Incentive Plan,  incorporated by reference to the Registrant’s current report on Form 8-K  filed with the Securities and Exchange Commission on May 24, 2005.                                                                                                 |
|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                                    |
| 10.2   | Form of Stock Option Grant Letter for Employees  of the Registrant under the 2005 Stock Incentive Plan, incorporated by reference to the  Registrant’s current report on Form 8-K filed with the Securities and  Exchange Commission on May 24, 2005.               |
|   |                                                                                                                                                                                                                                                                                    |
| 10.3   | Form of Stock Option Grant Letter for  Non-Employee Directors of the Registrant under the 2005 Stock Incentive Plan,  incorporated by  reference to the Registrant’s current report on Form 8-K filed with the  Securities and Exchange Commission on May 24, 2005. |
|   |                                                                                                                                                                                                                                                                                    |
| 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 requirementsof the Securities Exchange Act of 1934, the registrant has duly caused thisreport to be signed on its behalf by the undersigned thereunto duly authorized.

 
|                                         | PLC SYSTEMS INC. |
|----------------------------------------------|------------------|
|                                         |             |   |
| Date:   August 11,  2005 | By:              |  /s/ James G.  Thomasch |   |
|                                         |             |   James G.  Thomasch |
|                                         |             |   Chief  Financial Officer    (Principal Financial Officer and Chief    Accounting Officer) |

 

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**EXHIBIT INDEX**

 
| **Exhibit  Number** | ** ** | **Description of Document** |
|---------------------|------------|-----------------------------|
|                |       |                        |
| 10.1                |       |                        | 2005 Stock Incentive Plan,  incorporated by reference to the Registrant’s current report on Form 8-K  filed with the Securities and Exchange Commission on May 24, 2005. |
|                |       |                        |   |
| 10.2                |       |                        | Form of Stock Option Grant Letter for Employees  of the Registrant under the 2005 Stock Incentive Plan, incorporated by reference to the  Registrant’s current report on Form 8-K filed with the Securities and  Exchange Commission on May 24, 2005. |
|                |       |                        |   |
| 10.3                |       |                        | Form of Stock Option Grant Letter for  Non-Employee Directors of the Registrant under the 2005 Stock Incentive Plan,  incorporated by  reference to the Registrant’s current report on Form 8-K filed with the  Securities and Exchange Commission on May 24, 2005. |
|                |       |                        |   |
| 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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