**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,DC 20549**

**FORM 10-QSB**
| **x** | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|-------|------------|--------------------------------------------------------------------------------------------------------|

 

**FOR THEQUARTERLY PERIOD ENDED JULY 31, 2006**
| **o** | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|-------|------------|---------------------------------------------------------------------------------------------------------|

 

**CommissionFile Number 000-33295**

**MedicalCV, Inc.**

(Exact Name ofSmall Business Issuer as Specified in Its Charter)

| ** Minnesota**                |   | **41-1717208**       |
|------------------------------------|--------|----------------------|
| (State or Other  Jurisdiction      |   | (I.R.S. Employer     |
| of Incorporation  or Organization) |   | Identification  No.) |

 

**9725South Robert Trail**

**InverGrove Heights, Minnesota 55077**

**(651)452-3000**

(Address of PrincipalExecutive Offices and Issuer’s

Telephone Number,including Area Code)

Check whether theissuer:  (1) filed all reports required to be filed bySection 13 or 15(d) of the Exchange Act during the past 12 months (orsuch shorter period that the registrant was required to file such reports), and(2) has been subject to such filing requirements for the past 90 days.

Yes  x No  o

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

Yes  o No  x

As of September 8, 2006,the issuer had outstanding 9,122,938 shares of common stock, $0.01 par value.

Transitional SmallBusiness Disclosure Format (check one)   oYes   x No

 

----

TABLE OF CONTENTS
| PART I        | FINANCIAL  INFORMATION |                                                            |
|--------------------|------------------------|-----------------------------------------------------------------|
|               |                   |                                                            |   |
|               | ITEM 1                 | Condensed  Financial Statements                                 |   |
|               | ITEM 2                 | Management’s  Discussion and Analysis or Plan of Operation |   |
|               | ITEM 3                 | Controls and  Procedures                                        |   |
|               |                   |                                                            |   |
| PART II       | OTHER  INFORMATION     |                                                            |
|               |                   |                                                            |   |
|               | ITEM 1                 | Legal Proceedings                                               |   |
|               | ITEM  6                | Exhibits                                                        |   |
|               |                   |                                                            |   |
| SIGNATURES         |                   |
| INDEX  TO EXHIBITS |                   |

 

2

----

** **

**PART I**

**FINANCIALINFORMATION**

**ITEM 1****                                CONDENSEDFINANCIAL STATEMENTS**

**MEDICALCV, INC.**

**CONDENSEDBALANCE SHEETS**
| ** **                                                                                                                                                      | ** ** | **July 31,** | ** ** | **April 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|--------------------|------------|
| ** **                                                                                                                                                      | ** ** | **2006**          | ** ** | **2006**           | ** ** |
| ** **                                                                                                                                                      | ** ** | **(unaudited)**   | ** ** | ** **         | ** ** |
| **ASSETS**                                                                                                                                                      | ** ** | ** **        | ** ** | ** **         | ** ** |
| CURRENT ASSETS                                                                                                                                                  |       |              |       |               |       |
| Cash and cash  equivalents                                                                                                                                      |       | $                 | 7,147,911  |               | $          | 10,351,570 |   |
| Prepaid expenses  and other assets                                                                                                                              |       | 320,868           |       | 242,975            |       |
| Current assets  of discontinued operations                                                                                                                      |       | 89,782            |       | 89,782             |       |
| TOTAL CURRENT  ASSETS                                                                                                                                           |       | 7,558,561         |       | 10,684,327         |       |
|                                                                                                                                                            |       |              |       |               |       |
| PROPERTY, PLANT AND  EQUIPMENT, net                                                                                                                             |       | 703,753           |       | 740,010            |       |
| DEFERRED FINANCING  COSTS, net                                                                                                                                  |       | 49,121            |       | 50,942             |       |
| OTHER LONG-TERM ASSETS                                                                                                                                          |       | 23,400            |       | 23,400             |       |
| NON-CURRENT ASSETS OF  DISCONTINUED OPERATIONS                                                                                                                  |       | 64,877            |       | 87,323             |       |
| TOTAL ASSETS                                                                                                                                                    |       | $                 | 8,399,712  |               | $          | 11,586,002 |   |
|                                                                                                                                                            |       |              |       |               |       |
| **LIABILITIES,  CONVERTIBLE PREFERRED STOCK AND SHAREHOLDERS’ EQUITY**                                                                                     | ** ** | ** **        | ** ** | ** **         | ** ** |
| CURRENT LIABILITIES                                                                                                                                             |       |              |       |               |       |
| Accounts payable                                                                                                                                                |       | $                 | 885,622    |               | $          | 605,313 |   |
| Current portion  of related party lease obligation                                                                                                              |       | 325,553           |       | 322,586            |       |
| Accrued expenses                                                                                                                                                |       | 415,002           |       | 377,507            |       |
| TOTAL CURRENT  LIABILITIES                                                                                                                                      |       | 1,626,177         |       | 1,305,406          |       |
| RELATED PARTY LEASE  OBLIGATION, less current portion                                                                                                           |       | 2,459,723         |       | 2,542,233          |       |
| TOTAL  LIABILITIES                                                                                                                                              |       | 4,085,900         |       | 3,847,639          |       |
|                                                                                                                                                            |       |              |       |               |       |
| COMMITMENTS AND  CONTINGENCIES                                                                                                                                  |       |              |       |               |       |
|                                                                                                                                                            |       |              |       |               |       |
| 5% SERIES A REDEEMABLE  CONVERTIBLE PREFERRED STOCK; $.01 par value; stated value $10,000 per share;  1,900 shares authorized; no shares issued and outstanding |       | —            |       | —             |       |
|                                                                                                                                                            |       |              |       |               |       |
| SHAREHOLDERS’ EQUITY                                                                                                                                       |       |              |       |               |       |
| Preferred stock;  $.01 par value; 998,100 shares authorized; no shares issued and outstanding                                                                   |       | —            |       | —             |       |
| Common stock;  $.01 par value; 24,000,000 shares authorized; 9,122,938 and 9,122,946 shares issued  and outstanding                                             |       | 91,229            |       | 91,229             |       |
| Additional  paid-in capital                                                                                                                                     |       | 55,663,233        |       | 55,088,734         |       |
| Deferred  stock-based compensation                                                                                                                              |       | —            |       | (98,512            | )          |
| Accumulated  deficit                                                                                                                                            |       | (51,440,650       | )          | (47,343,088        | )          |
| TOTAL  SHAREHOLDERS’ EQUITY                                                                                                                                |       | 4,313,812         |       | 7,738,363          |       |
| TOTAL LIABILITIES,  CONVERTIBLE PREFERRED STOCK AND SHAREHOLDERS’ EQUITY                                                                                   |       | $                 | 8,399,712  |               | $          | 11,586,002 |   |

 

See notes tocondensed financial statements.

3

----

**MEDICALCV, INC.**

**CONDENSEDSTATEMENTS OF OPERATIONS**

**(UNAUDITED)**
| ** **                                                                                          | ** ** | **Three months ended July 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                          | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
| OPERATING EXPENSES,  CONTINUING OPERATIONS                                                          |       |                                                |       |   |   |
|  Sales and  marketing                                                                          |       | $                                                   | 390,682    |   | $ | 105,217 |   |
|  General and  administrative                                                                   |       | 2,217,613                                           |       | 763,329 |   |
|  Research and  development                                                                     |       | 1,588,362                                           |       | 403,225 |   |
| TOTAL OPERATING EXPENSES                                                                            |       | 4,196,657                                           |       | 1,271,771 |   |
| LOSS FROM  OPERATIONS                                                                               |       | (4,196,657                                          | )          | (1,271,771 | ) |
|                                                                                                |       |                                                |       |   |   |
| OTHER INCOME  (EXPENSE)                                                                             |       |                                                |       |   |   |
|  Interest  income                                                                              |       | 108,349                                             |       | 68,962 |   |
|  Interest  expense                                                                             |       | (37,235                                             | )          | (79,036 | ) |
|  Other income                                                                                  |       | 18,927                                              |       | 1,060 |   |
|  Decrease in  fair value of putable warrants                                                   |       | —                                              |       | 6,453,938 |   |
| TOTAL OTHER INCOME (EXPENSE)                                                                        |       | 90,041                                              |       | 6,444,924 |   |
|                                                                                                |       |                                                |       |   |   |
| (LOSS) INCOME  FROM CONTINUING OPERATIONS                                                           |       | (4,106,616                                          | )          | 5,173,153 |   |
|                                                                                                |       |                                                |       |   |   |
| INCOME (LOSS)  FROM DISCONTINUED OPERATIONS                                                         |       | 9,054                                               |       | (102,969 | ) |
| NET (LOSS)  INCOME                                                                                  |       | $                                                   | (4,097,562 | ) | $ | 5,070,184 |   |
|                                                                                                |       |                                                |       |   |   |
| BASIC AND  DILUTED NET (LOSS) INCOME TO COMMON SHAREHOLDERS                                         |       |                                                |       |   |   |
|  Net (loss)  income                                                                            |       | $                                                   | (4,097,562 | ) | $ | 5,070,184 |   |
|  Redeemable  convertible preferred stock cash dividends                                        |       | —                                              |       | (218,633 | ) |
| NET (LOSS)  INCOME TO COMMON SHAREHOLDERS                                                           |       | $                                                   | (4,097,562 | ) | $ | 4,851,551 |   |
|                                                                                                |       |                                                |       |   |   |
| NET (LOSS)  EARNINGS PER COMMON SHARE – CONTINUING OPERATIONS,  AFTER PREFERRED DIVIDENDS |       |                                                |       |   |   |
| Basic                                                                                               |       | $                                                   | (0.45      | ) | $ | 4.49 |   |
| Diluted                                                                                             |       | (0.45                                               | )          | (0.70 | ) |
|                                                                                                |       |                                                |       |   |   |
| NET EARNINGS  (LOSS) PER COMMON SHARE – DISCONTINUED OPERATIONS                                |       |                                                |       |   |   |
| Basic                                                                                               |       | 0.00                                                |       | (0.09 | ) |
| Diluted                                                                                             |       | 0.00                                                |       | (0.05 | ) |
|                                                                                                |       |                                                |       |   |   |
| NET (LOSS)  EARNINGS PER COMMON SHARE                                                               |       |                                                |       |   |   |
| Basic                                                                                               |       | (0.45                                               | )          | 4.40 |   |
| Diluted                                                                                             |       | (0.45                                               | )          | (0.75 | ) |
|                                                                                                |       |                                                |       |   |   |
| WEIGHTED-AVERAGE  COMMON SHARES OUTSTANDING                                                         |       |                                                |       |   |   |
| Basic                                                                                               |       | 9,122,941                                           |       | 1,102,442 |   |
| Diluted                                                                                             |       | 9,122,941                                           |       | 2,139,374 |   |

 

See notes tocondensed financial statements.

4

----

**MEDICALCV,INC.**

**CONDENSEDSTATEMENTS OF CASH FLOWS**

**(UNAUDITED)**
| ** **                                                                                  | ** ** | **Three months ended July 31,** | ** ** |
|---------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                  | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
| OPERATING  ACTIVITIES                                                                       |       |                                                |       |   |   |
|  Net (loss)  income                                                                    |       | $                                                   | (4,097,562 | ) | $ | 5,070,184 |   |
|  Adjustments  to reconcile net (loss) income to net cash used by operating activities: |       |                                                |       |   |   |
| Decrease in fair value of putable warrants                                                  |       | —                                              |       | (6,453,938 | ) |
| Depreciation and amortization                                                               |       | 32,821                                              |       | 56,248 |   |
| Impairment of fixed assets                                                                  |       | 20,753                                              |       | — |   |
| Gain from the sales of property, plant and equipment                                        |       | (49,649                                             | )          | — |   |
| Stock-based compensation                                                                    |       | 673,240                                             |       | — |   |
| Changes in operating assets and liabilities:                                                |       |                                                |       |   |   |
| Prepaid expenses and other assets                                                           |       | (55,447                                             | )          | 453,788 |   |
| Accounts payable                                                                            |       | 280,309                                             |       | (291,039 | ) |
| Accrued expenses                                                                            |       | 37,495                                              |       | (97,482 | ) |
| NET CASH USED BY OPERATING ACTIVITIES                                                       |       | (3,158,040                                          | )          | (1,262,239 | ) |
| INVESTING  ACTIVITIES                                                                       |       |                                                |       |   |   |
|  Purchases of  property, plant and equipment                                           |       | (16,515                                             | )          | (238,682 | ) |
|  Proceeds from  the sales of property, plant and equipment                             |       | 50,668                                              |       | — |   |
| NET CASH PROVIDED (USED) BY INVESTING ACTIVITIES                                            |       | 34,153                                              |       | (238,682 | ) |
| FINANCING  ACTIVITIES                                                                       |       |                                                |       |   |   |
|  Principal  payments under related party lease obligation                              |       | (79,543                                             | )          | (35,563 | ) |
|  Payments of  fractional share interests                                               |       | (229                                                | )          | — |   |
|  Proceeds from  exercise of stock options                                              |       | —                                              |       | 1,125 |   |
|  Preferred  stock cash dividends                                                       |       | —                                              |       | (218,633 | ) |
| NET CASH USED BY FINANCING ACTIVITIES                                                       |       | (79,772                                             | )          | (253,071 | ) |
| NET DECREASE IN  CASH AND CASH EQUIVALENTS                                                  |       | (3,203,659                                          | )          | (1,753,992 | ) |
|                                                                                        |       |                                                |       |   |   |
| CASH AND CASH  EQUIVALENTS                                                                  |       |                                                |       |   |   |
| Beginning of year                                                                           |       | 10,351,570                                          |       | 10,637,796 |   |
| End of period                                                                               |       | $                                                   | 7,147,911  |   | $ | 8,883,804 |   |
| SUPPLEMENTAL DISCLOSURES  OF CASH FLOW INFORMATION                                          |       |                                                |       |   |   |
|  Cash paid for interest                                                                |       | $                                                   | 37,235     |   | $ | 79,036 |   |

 

See notes tocondensed financial statements.

5

----

**MEDICALCV,INC.**

**Notesto Condensed Financial Statements**

**1.             Basis of Financial StatementPresentation**

The accompanyingunaudited condensed financial statements included herein have been prepared byMedicalCV, Inc. (the “Company”) in accordance with accounting principlesgenerally accepted in the United States of America for interim financialinformation and pursuant to the rules and regulations of the Securitiesand Exchange Commission.  Certain information and footnote disclosuresnormally included in financial statements prepared in accordance withaccounting principles generally accepted in the United States of America havebeen condensed or omitted pursuant to such rules and regulations. These interim financial statements should be read in conjunction with thefinancial statements and the notes thereto included in the Company’s AnnualReport on Form 10-KSB for the fiscal year ended April 30, 2006.

The balance sheet as ofJuly 31, 2006, the statements of operations for the three months endedJuly 31, 2006 and 2005, and the statements of cash flows for the three monthsended July 31, 2006 and 2005 include, in the opinion of management, alladjustments, consisting solely of normal recurring adjustments, necessary for afair presentation of the financial results for the respective interim periodsand are not necessarily indicative of results of operations to be expected forthe entire fiscal year ending April 30, 2007.

**2.             Going Concern**

The Company’s financialstatements as of and for the three months ended July 31, 2006 have beenprepared on a going concern basis, which contemplates the realization of assetsand settlement of liabilities and commitments in the normal course ofbusiness.  The Company has sustained losses and negative cash flows fromoperations in recent years and expects these conditions to continue for theforeseeable future.  At July 31, 2006, the Company had an accumulateddeficit of $51,440,650.  The level ofcash required for operations during the remaining quarters of fiscal year 2007is difficult to predict, and management anticipates that development of its newproduct will require additional capital. These matters raise substantial doubt about the Company’s ability tocontinue as a going concern.  Management intends to seek additional debtor equity financing as it continues to develop its new product.  However,the Company may not be able to obtain such financing on acceptable terms or atall.  If the Company is unable to obtain such additional financing, itwill be required to significantly revise its business plan and drasticallyreduce operating expenditures such that it may not be able to develop orenhance its product, gain market share in the United States of America orrespond to competitive pressures or unanticipated requirements, which couldseriously harm its business, financial position and results of operations.  The financial statements do not include anyadjustments that might result from the outcome of this uncertainty.  

6

----

**3.             Net (Loss) Earnings per CommonShare**

Basic net (loss) earningsper common share was computed by dividing the net (loss) income to commonshareholders by the weighted average number of common shares outstanding. Diluted net loss per common share reflects the potential dilution that couldoccur if holders of warrants and options that are not anti-dilutive converttheir holdings into common stock. Diluted net loss per common share does not differ from basic net lossper common share in the three months ended July 31, 2006 since the potentiallydilutive shares are anti-dilutive. Certain warrants outstanding during the three months ended July 31, 2005were potentially dilutive and considered to be common stock equivalents.  The net earnings to common shareholders forthe three months ended July 31, 2005 was adjusted for the decrease in fairvalue of putable warrants and the weighted average number of shares used forthe basic net earnings per share computation was increased by the sharesissuable under the warrants as follows:

|                                                                                          | ** ** | **Three months ended July 31,** | ** ** |
|------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                               | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
| Numerator:                                                                               |       |                                                |       |   |   |
| Net (loss)  income to common shareholders for basic net (loss) earnings per common share |       | $                                                   | (4,097,562 | ) | $ | 4,851,551 |   |
| Effect of  dilutive securities – decrease in fair value of putable warrants         |       | —                                              |       | (6,453,938 | ) |
| Net loss to common  shareholders for diluted loss per common share                       |       | $                                                   | (4,097,562 | ) | $ | (1,602,387 | ) |

 

|                                                                                     | ** ** | **Three months ended July 31,** | ** ** |
|-------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                          | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
| Denominator:                                                                        |       |                                                |       |   |   |
| Weighted average  shares outstanding for basic net (loss) earnings per common share |       | 9,122,941                                           |       | 1,102,442 |   |
| Effect of  dilutive securities – shares issuable under warrant agreements      |       | —                                              |       | 1,036,932 |   |
| Weighted average shares  outstanding for diluted net loss per common share          |       | 9,122,941                                           |       | 2,139,374 |   |

 

Options and warrants topurchase 2,159,351 and 515,118 shares of common stock were excluded from thecomputation for the three months ended July 31, 2006 and 2005, respectively,because they were anti-dilutive.  

**4.             Stock-Based Compensation**

On May 1, 2006, theCompany adopted Statement of Financial Accounting Standards (“SFAS”) No. 123R(revised 2004), *Share-Based Payment,*and electedthe modified prospective application transition method.  SFAS No. 123R is a revision of SFAS No. 123, *Accounting for Stock-Based Compensation*, and supersedesAccounting Principles Board (“APB”) Opinion No. 25, *Accountingfor Stock Issued to Employees*, and its related guidance.  As required by SFAS No. 123R, the Companyrecognizes compensation expense during the vesting period of stock-based awardsthat are granted, modified, repurchased, or cancelled after May 1, 2006 usingthe grant-date fair value of the award. In addition, compensation expense is recognized for awards granted priorto, but not yet vested as of May 1, 2006, based on the grant date fair value ofthe award.  In accordance with themodified prospective application transition method of SFAS No. 123R, priorperiod results are not restated. Incremental compensation cost for a modification of the terms orconditions of an award is measured by comparing the fair value of the modifiedaward with the fair value of the award immediately before themodification.  The Company has alsoimplemented the SEC interpretations in Staff Accounting Bulletin (“SAB”) No.107, *Share-Based Payments,*in connection withthe adoption of SFAS No. 123R.     

Prior to the adoption ofSFAS No. 123R, the Company accounted for stock options granted to employeesusing the intrinsic value method under the guidance of APB No. 25, and providedpro forma disclosure as required by SFAS No. 123.  No stock-based compensation cost wasrecognized in the statement of operations for the three months ended July 31,2005 as all options granted had an exercise price equal to the market value ofthe underlying common stock of the Company at the date of grant.  Stock options issued to non-employees wereaccounted for as required by SFAS No. 123. However, no stock options were granted to non-employees during the threemonths ended July 31, 2005.  

7

----

*Stock-Based Compensation Expense*

Stock-based compensationis classified in the same expense lines as cash compensation in accordance withSAB No. 107.  Stock-based compensationexpense included in the statement of operations as a result of adopting SFASNo. 123R is as follows:  
| ** **                                                                         | ** ** | **Three months  ended July 31, 2006** | ** ** |
|------------------------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| Sales and  marketing                                                               |       | $                                                         | 22,054     |   |
| General and  administrative                                                        |       | 530,841                                                   |       |
| Research and  development (1)                                                      |       | 120,345                                                   |       |
| Total  stock-based compensation                                                    |       | $                                                         | 673,240    |   |
|                                                                               |       |                                                      |       |
| Impact of adopting SFAS  No. 123R on reported basic and diluted net loss per share |       | $                                                         | (0.07      | ) |

----

(1) Includes$14,910 of stock-based compensation expense related to non-employees.

The Company recognizescompensation expense for stock options on a straight-line basis over therequisite service period of the award. The amount of stock-based compensation recognized is based on the valueof the portions of the awards that are ultimately expected to vest.  SFAS No. 123R requires forfeitures to beestimated at the time of grant and revised, if necessary, in subsequent periodsif actual forfeitures differ from those estimates.  No compensation cost is recognized forinstruments that employees forfeit because the requisite service is notrendered.  Previously recognized compensationcost is not reversed if an employee stock option for which the requisiteservice has been rendered expires unexercised. The Company uses historical forfeitures and employee turnover toestimate the number of options that will actually vest.  The Company will reevaluate this estimateperiodically and adjust the forfeiture rate on a prospective basis asnecessary.    

In accordance with themodified prospective application transition method of SFAS No. 123R, financialresults for prior periods have not been restated.  For purposes of the pro forma disclosuresrequired by SFAS No. 123, the Company amortized the grant-date fair value ofemployee stock options over the vesting period and accounted for forfeitures asthey occurred.  The following tableillustrates the effect on net income and net earnings (loss) per share if theCompany had recorded compensation expense for employee stock options under theprovisions of SFAS No. 123 for the three months ended July 31, 2005:  
| ** **                                            | ** ** | **Three months  ended July 31, 2005** | ** ** |
|-------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| Net income to  common shareholders – as reported |       | $                                                         | 4,851,551  |   |
| Stock-based  employee compensation expense            |       | (382,181                                                  | )          |
| Net income to  common shareholders – pro forma   |       | $                                                         | 4,469,370  |   |
|                                                  |       |                                                      |       |
| Basic net  earnings per common share                  |       |                                                      |       |
|  As reported                                     |       | $                                                         | 4.40       |   |
|  Pro forma                                       |       | 4.05                                                      |       |
|                                                  |       |                                                      |       |
| Diluted net loss  per common share                    |       |                                                      |       |
|  As reported                                     |       | (0.75                                                     | )          |
|  Pro forma                                       |       | (0.93                                                     | )          |

 

8

----

SFAS No. 123R requiresthe cash flows from the tax benefits resulting from tax deductions in excess ofthe compensation cost recognized for those options (“excess tax benefits”) tobe classified as financing cash flows. Due to the Company’s history of net operating losses and current taxposition, there are not any material excess tax benefits.   

As of July 31, 2006,there was $3,897,801 of total unrecognized stock-based compensation cost andthe Company expects that cost to be recognized over a weighted-averagerecognition period of 2.8 years.  

*Stock Option Activity*

At July 31, 2006, 362,905shares remain available for grant under the Company’s five authorized stockoption plans.  Of the 949,535 options outstandingat July 31, 2006, 557,365 were issued outside of the authorized plans.  Generally, the exercise price of an option isset at the price of the Company’s stock on the grant date.  Options typically vest over four years andhave a maximum contractual term of ten years. Certain option awards provide for accelerated vesting if there is achange in control.    

The following tablesummarizes information about stock options for the three months ended July 31,2006:
| ** **                                  | ** ** | **Options** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted Average  Remaining  Contractual Term  (in years)** | ** ** | **Aggregate  Intrinsic  Value (1)** | ** ** |
|---------------------------------------------|------------|-------------|------------|----------------------------------------|------------|-------------------------------------------------------------------------|------------|------------------------------------------|------------|
| Outstanding,  April 30, 2006                |       | 903,253     |       | $                                      | 9.70       |                                                                    |       |                                     |       |   |
| Granted                                     |       | 146,229     |       | 7.66                                   |       |                                                                    |       |                                     |       |
| Exercised                                   |       | —      |       | —                                 |       |                                                                    |       |                                     |       |
| Forfeited/Expired                           |       | (99,947     | )          | 10.23                                  |       |                                                                    |       |                                     |       |
| Outstanding,  July 31, 2006                 |       | 949,535     |       | 9.33                                   |       | 6.9                                                                     |       | $                                        | 180        |   |
| Vested and  expected to vest, July 31, 2006 |       | 824,744     |       | 9.43                                   |       | 6.9                                                                     |       | $                                        | 180        |   |
| Exercisable, July 31,  2006                 |       | 313,775     |       | 10.53                                  |       | 6.5                                                                     |       | $                                        | 180        |   |
|                                             |            |             |            |                                        |            |                                                                         |            |                                          |            |  |  |

 

----

(1)  This disclosure excludes those options thathave no intrinsic value (i.e. those options that are out of the money using theclosing market price of the Company’s stock on July 31, 2006 of $5.30 pershare).  

9

----

On May 10, 2006, theCompany awarded non-qualified stock options for the purchase of 5,000 shares ofcommon stock to each of the Company’s six non-employee directors.  The options vest immediately, are exercisableat $10.50 per share, and expire on May 10, 2016.  In addition, the Company awarded anon-qualified stock option for the purchase of 25,000 shares of common stock tothe Vice President, Marketing.  Theoption vests over 4 years, is exercisable at $10.50 per share, and expires onMay 10, 2016. 

On June 21, 2006, theCompany awarded a non-qualified stock option for the purchase of 91,229 sharesof common stock to the Vice President, Finance and Chief FinancialOfficer.  The option vests over 4 years,is exercisable at $5.95 per share, and expires on June 21, 2016.

Net cash proceeds fromthe exercise of stock options were $1,125 in the three months ended July 31,2005.  The aggregate intrinsic value ofoptions exercised (the amount by which the market price of the stock on date ofexercise exceeded the market price of the stock on the date of grant) was$2,063 during the three months ended July 31, 2005.  Due to the Company’s current tax position, notax benefit was recognized as a result of option exercises in the three monthsended July 31, 2005.  There were no stockoptions exercised during the three months ended July 31, 2006.  The Company issues new shares for stockoptions exercised. 

*Stock Option Valuation*

The Company uses theBlack-Scholes-Merton formula to estimate the grant date fair value of its stockoptions using the following assumptions:

|                                         | ** ** | **Three months ended July 31,** | ** ** |
|-----------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                              | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
| Options granted                         |       | 146,229                                             |       | 20,500 |   |
| Weighted average  exercise price        |       | $                                                   | 7.66       |   | $ | 7.50 |   |
| Weighted average  grant date fair value |       | $                                                   | 6.25       |   | $ | 7.31 |   |
| Expected  dividend yield rate (1)       |       | 0                                                   | %          | 0 | % |
| Risk free  interest rate (2)            |       | 5.0 to 5.1                                          | %          | 4.2 | % |
| Expected term  (3)                      |       | 5.0 to 6.3 years                                    |       | 10 years |   |
| Expected  volatility (4)                |       | 111.1 to 111.2                                      | %          | 136.0 | % |
| Weighted-average  volatility            |       | 111.1                                               | %          | 136.0 | % |

 

----

**(1) Expected dividend yield rate** – The Company has nothistorically paid a cash dividend and does not intend to pay dividends in the future.  Therefore, the Company has assumed anexpected dividend yield rate of zero.   

**(2)  Riskfree interest rate** – The Company uses yield rates on U.S.Treasury securities for a period approximating the expected term of the awardto estimate the risk-free interest rate in its grant-date fair valueassessment.  For fiscal year 2007, therate is based on the U.S. Treasury interest rates whose term is consistent withthe expected term of the stock option. For fiscal year 2006, the rate was based on the U.S. Treasury interestrate for the term consistent with the maturity of the option.

**(3) Expected term** – Due to the limited number ofhistorical stock options exercised, the Company has elected to use the “simplified”method for estimating the expected terms of options in fiscal year 2007 asallowed under SAB 107.  Under thisapproach, the expected term was calculated by taking the average of the vestingterm and the original contract term.  Infiscal year 2006, the Company used the contractual life of the option as theexpected term.    

**(4) Expected volatility** – For stock option grants infiscal year 2007, the Company uses at least three years of historical monthlyprice observations to estimate volatility. For stock option grants in fiscal year 2006, the Company used weeklyprice observations beginning in August 2003, the date of acquisition of certaintechnology used in continuing operations.

10

----

**5.             Shareholders’ Equity**

**RegistrationStatement for Public Offering of Common Stock**

On August 8, 2006, theCompany requested withdrawal of its registration statement on Form SB-2originally filed with the Securities and Exchange Commission on May 19, 2006related to a proposed public offering of common stock.  Due to unsettled conditions in the equitymarkets, the Company decided not to pursue a public offering at that time.  

**ReverseStock Split**

On May 31, 2006, theCompany effected a reverse stock split pursuant to which every ten shares ofcommon stock and every ten shares of preferred stock were combined into one shareof common stock and one share of preferred stock, respectively, without anychange in the par value of the shares. The authorized capital stock was reduced in like manner.  No fractional shares were issued as a resultof the reverse split, and $229 has been paid for fractional shareinterests.  The reverse split wasapproved by the Company’s board of directors without shareholder approval inaccordance with the requirements of Minnesota law.  Historical share data presented herein givesretroactive effect to this reverse stock split.

**StockWarrants**

The Company had warrantsoutstanding to purchase 1,168,498 shares of the Company’s common stock atprices ranging from $3.25 to $67.50 per share at July 31, 2006 and April 30,2006.  The warrants expire at variousdates through March 2015.  

**6.             Employment Agreements**

**Current Vice President, Financeand Chief Financial Officer**

In May 2006, the Company entered into a written, at-will employmentagreement with Eapen Chacko, who joined the Company on June 21, 2006, as VicePresident, Finance and Chief Financial Officer. Mr. Chacko assumed the roles of principal financial officer andprincipal accounting officer effective at the close of business on July 31,2006.  Mr. Chacko receives an annual basesalary of $200,000 and is eligible to receive performance-based cashbonuses.  The employment agreementprovides that a severance payment will be made if the employment is terminatedby the Company without cause, or by the employee for good reason, including,but not limited to, a reduction of the employee’s compensation; a reduction ofauthority and responsibility; a relocation of place of employment; or a breachof the employment agreement by the Company. The severance payment would be six months of base salary and, if at theend of such six-month period, Mr. Chacko is not employed or engaged as anindependent contractor, the Company would pay him up to an additional sixmonths of base salary until he is employed or engaged as an independentcontractor.  In addition to payments ofbase salary, the Company has agreed to pay or reimburse Mr. Chacko for medical(COBRA) benefits for the periods covered by the severance payments.  In addition, Mr. Chacko has agreed to certainnondisclosure and invention provisions and certain noncompetition andnonrecruitment provisions during the term of employment and for a period of oneyear after termination of employment.

 

**Former Vice President, Financeand Chief Financial Officer**

In April 2006, theCompany entered into an amendment to the employment agreement (the “FirstAmendment”) with John H. Jungbauer, then the Company’s Vice President, Financeand Chief Financial Officer, to reflect the mutual decision reached concerningMr. Jungbauer’s departure from the Company. Mr. Jungbauer’s employment ceased effective at the close of business onJuly 31, 2006.  A severance payment of$100,000 was paid on July 31, 2006 and an additional $100,000 will be paid toMr. Jungbauer in January 2007.  Inaddition to these severance payments, the Company has agreed to pay orreimburse Mr. Jungbauer for medical (COBRA) benefits.  The Company recorded $94,291 in the threemonths ended July 31, 2006 and $131,793 in fiscal year 2006 related to theseverance payments, related payroll taxes, and medical benefits.

11

----

In connection with theFirst Amendment, the Company agreed to amend Mr. Jungbauer’s stock optionagreements to provide that his options, to the extent vested on the terminationdate, would be exercisable for a period of twelve months following the terminationof Mr. Jungbauer’s employment.  Theoriginal terms of Mr. Jungbauer’s stock option agreements for the purchase of144,012 shares of the Company’s common stock provided that he had three monthsfollowing termination of employment to exercise the vested portions.  The Company accounted for the modification inaccordance with the provisions of APB No. 25 and recorded compensation expenseof $87,353 in fiscal year 2006 to reflect the intrinsic value of the excess ofthe market price of the Company’s common stock at the date of modification overthe exercise price of the vested stock options. 

In July 2006, the Companyentered into a second amendment to the employment agreement (the “SecondAmendment”) with Mr. Jungbauer to retroactively rescind the provision in theFirst Amendment that provided Mr. Jungbauer twelve months following terminationof employment to exercise the vested portions of his stock options and revertto the original terms of the stock option agreements that provide Mr. Jungbauerthree months following termination of employment to exercise the vestedportions thereof.  Options to purchase44,065 shares of the Company’s common stock had vested as of July 31,2006.  The Company accounted for thesubsequent modification of the exercise period in fiscal year 2007 inaccordance with the provisions of SFAS No. 123R.  Accordingly, no incremental compensation wasrecorded in fiscal year 2007 as the fair value of the modified stock optionagreements was less than the fair value immediately before themodification.    

**Other Separations**

During the three monthsended July 31, 2005, the Company entered into a separation agreement with anemployee, resulting in a charge to general and administrative expense forseverance pay of $40,382.    

The following tablesummarizes the severance charges:  
| Balance as of April 30, 2005                                |   | $        | 24,834  |   |
|-------------------------------------------------------------|--------|----------|---------|--------|
| Severance  charges in fiscal year 2006                      |   | 172,175  |    |
| Cash usage in  fiscal year 2006                             |   | (65,216  | )       |
| Balance as of  April 30, 2006                               |   | 131,793  |    |
| Severance charges  in the first quarter of fiscal year 2007 |   | 94,291   |    |
| Cash usage in  the first quarter of fiscal year 2007        |   | (100,000 | )       |
| Balance as of July 31,  2006                                |   | $        | 126,084 |   |

 

12

----

**7.             Litigation**

On March 10, 2006, JGiordano Securities LLC (d/b/a J Giordano Securities Group) (“JGSG”) filed suitagainst the Company in U.S. District Court for the District ofConnecticut.  JGSG, which acted as aprivate placement agent for the Company in connection with sales of the Company’ssecurities to private investors in April 2005, asserts claims for breach ofcontract, unjust enrichment and quantum meruit. JGSG contends it is owed certain fees as a result of “follow ontransactions” executed by investors identified by JGSG, pursuant to theengagement agreement, as amended, between the Company and JGSG or, in thealternative, that it should be awarded such fees on an equitable basis.  In particular, JGSG claims that the exerciseof outstanding warrants for the purchase of common stock by certain JGSG-identifiedinvestors and the Company’s purchase of outstanding shares of 5% Series ARedeemable Convertible Preferred Stock from certain JGSG-identified investorsin December 2005 and January 2006 entitle JGSG to damages no less than$1,431,769.  JGSG seeks (a) $279,191 incash commissions, (b) warrants for the purchase of 85,905 shares at $3.25 pershare, (c) lost profits of $751,669 on the argument that JGSG would haveexercised the foregoing warrant and sold 85,905 shares on December 30, 2005, ata price of $12.00 per share, and (d) the $400,909 in cash commissions theCompany paid C.E. Unterberg, Towbin, LLC. JGSG also seeks reimbursement for reasonable expenses, interest, costsand attorneys’ fees.  The U.S. DistrictCourt for the District of Connecticut has referred the matter to NASD arbitration;however, there remains a motion to determine the venue of the NASD arbitrationpending before the federal court.  

On May 26, 2006, JGSGnotified the Company by letter that, pursuant to the agreement, it may claimcompensation arising out of alleged rights to serve as a co-managingunderwriter or member of the underwriting group of a proposed public offeringset forth in the registration statement on Form SB-2 the Company filed with theSecurities and Exchange Commission on May 19, 2006.  Due to market conditions, the Companyrequested a withdrawal of such registration statement on August 9, 2006.  

The Company believes thatthis lawsuit is without merit and intends to vigorously defend itself.

13

----

**8.             Discontinued Operations**

On November 17,2004, the Company’s board of directors authorized management to ceaseproduction of heart valves but to continue marketing the valves while exploringthe merits of possible strategic alternatives for the heart valve business,including, but not limited to, a joint venture with another party or the saleof the business.  Following exploration of a number of alternatives,management concluded in April 2005 that an orderly winding up of the valvebusiness was the Company’s best alternative.  On April 6, 2005, theCompany’s board authorized management to discontinue sales and marketing ofheart valves effective April 30, 2005, and to seek a buyer for the relatedproduction equipment.

As a result of theCompany’s discontinuance of the heart valve business, the Company made adetermination during the fourth quarter of fiscal year 2005 that the remainingassets of the heart valve operations should be considered “held for sale”pursuant to SFAS No. 144, “Accounting for Impairment or Disposal ofLong-Lived Assets.”  Pursuant to SFAS No. 144, the Company ceaseddepreciation of property and equipment held for sale and evaluated whether anyof the long-lived assets of the discontinued heart valve business wereimpaired.  Based upon the estimated selling prices of these assets, managementconcluded that the carrying value of these assets was not impaired.  The Company has sold or disposed of themajority of the equipment and the carrying value of the remaining net assets ofthe heart valve business are reported as assets of discontinued operations onthe Company’s balance sheet.    

Valve business revenuesand income (loss) before income taxes included in discontinued operations areas follows:
|                                    | ** ** | **Three months ended July 31,** | ** ** |
|------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                         | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
| Revenues                           |       | $                                                   | —     |   | $ | 338,333 |   |
| Income (loss) before  income taxes |       | $                                                   | 9,054      |   | $ | (102,969 | ) |

 

The carrying amounts andmajor classes of the assets, which are presented as assets of discontinuedoperations on the accompanying balance sheets are as follows:
|                                                      | ** ** | **July 31, 2006** | ** ** | **April 30, 2006** | ** ** |
|------------------------------------------------------|------------|-----------------------------|------------|------------------------------|------------|
| Prepaid expenses                                     |       | $                           | 89,782     |                         | $          | 89,782 |   |
| Total current  assets of discontinued operations     |       | 89,782                      |       | 89,782                       |       |
|                                                 |       |                        |       |                         |       |
| Property, plant  and equipment, net                  |       | —                      |       | —                       |       |
| Other long-term  assets                              |       | 64,877                      |       | 87,323                       |       |
| Total  non-current assets of discontinued operations |       | 64,877                      |       | 87,323                       |       |
|                                                 |       |                        |       |                         |       |
| Assets of discontinued  operations                   |       | $                           | 154,659    |                         | $          | 177,105 |   |

 

**9.             Geographic Information**

The following tablesummarizes net sales, all of which are reported as part of discontinuedoperations, by geographic area:  
|               | ** ** | **Three months ended July 31,** | ** ** |
|---------------|------------|-----------------------------------------------------|------------|
| ** **    | ** ** | **2006**                                            | ** ** | **2005** | ** ** |
| Europe        |       | $                                                   | —     |   | $ | 279,435 |   |
| United States |       | —                                              |       | 58,898 |   |
| Total         |       | $                                                   | —     |   | $ | 338,333 |   |

 

Substantially all of theCompany’s operations and assets were based in the United States for all periodspresented.

14

----

**ITEM 2   MANAGEMENT’S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION**

 

*Thefollowing discussion contains various forward-looking statements within themeaning of Section 21E of the Exchange Act.  Although we believethat, in making any such statement, our expectations are based on reasonableassumptions, any such statement may be influenced by factors that could causeactual outcomes and results to be materially different from thoseprojected.  When used in the following discussion, the words “anticipates,”“believes,” “expects,” “intends,” “plans,” “estimates” and similar expressions,as they relate to us or our management, are intended to identify suchforward-looking statements.  These forward-looking statements are subjectto numerous risks and uncertainties that could cause actual results to differmaterially from those anticipated.  Factors that could cause actualresults to differ materially from those anticipated, certain of which arebeyond our control, are set forth in this document and in our Annual Report onForm 10-KSB for the fiscal year ended April 30, 2006, under thecaption “Management’s Discussion and Analysis or Plan of Operation — CautionaryStatement.”*

*Ouractual results, performance or achievements could differ materially from thoseexpressed in, or implied by, forward-looking statements.  Accordingly, wecannot be certain that any of the events anticipated by forward-lookingstatements will occur or, if any of them do occur, what impact they will haveon us.  We caution you to keep in mind the cautions and risks described inthis document and in our Cautionary Statement and to refrain from attributingundue certainty to any forward-looking statements, which speak only as of thedate of the document in which they appear. We do not undertake to update any forward-looking statement.*

**Overview**

Our ATRILAZETM surgicalablation system utilizes laser energy to ablate cardiac tissue.  We acquired the initial technology inAugust 2003 and we have developed several generations of products beyondthe initial technology purchase.  Wereceived FDA 510(k) clearances for the first generation product in November2004 and the second generation product in October 2005.  In addition, wereceived a third 510(k) clearance in April 2006 which covered an additionallaser wavelength.

The ATRILAZE system withits laser technology platform is currently being utilized to ablate cardiactissue concomitantly, or in conjunction, with open-heart surgical procedures.  Our strategy is to leverage our existinglaser technology to develop a stand-alone, minimally invasive treatment foratrial fibrillation (“AF”).  AF is themost commonly occurring cardiac arrhythmia. It reduces cardiac output, is a major precursor to congestive heartfailure and is associated with an increased incidence of stroke.  We define a minimally invasive treatment asbeing one in which the procedure is performed on a beating heart in aclosed-chest setting.  We submitted anapplication for FDA 510(k) clearance of our minimally invasive system for cardiactissue ablation in May 2006 and expect final clearance before we introduce ourATRILAZE minimally invasive system in the second half of calendar year 2006.

Our company wasincorporated in Minnesota on March 30, 1992, under the name CV Dynamics, Inc.  In April 1992, we acquired all of thetangible and intangible assets of Omnicor, Inc. Omnicor resulted from the corporate and financial restructuring of apredecessor company called Medical Incorporated, which was organized in 1971 todevelop and market the Lillehei-Kaster heart valve, licensed from theUniversity of Minnesota.

Until November 2004, wedeveloped and marketed mechanical heart valves known as the Omnicarbon® 3000and 4000 heart valves.  In November 2004, after an exhaustiveevaluation of the heart valve business, we discontinued all heart valve relatedproduction.  In April 2005, we announced that our efforts to find abuyer for the heart valve business had been unsuccessful and that we would stopselling heart valves and were exiting the heart valve business.  At thattime, we also determined to direct all of our resources to the development andintroduction of products targeting the treatment of AF.

15

----

**CriticalAccounting Policies**

For discussion of ourcritical accounting policies and estimates, see our Annual Report onForm 10-KSB for the fiscal year ended April 30, 2006.

On May 1, 2006, weadopted Statement of Financial Accounting Standards (“SFAS”) No. 123R (revised2004), *Share-Based Payment,*and elected themodified prospective application transition method.  SFAS No. 123R is a revision of SFAS No. 123, *Accounting for Stock-Based Compensation*, and supersedesAccounting Principles Board (“APB”) Opinion No. 25, *Accountingfor Stock Issued to Employees*, and its related guidance.  As required by SFAS No. 123R, we recognizecompensation expense during the vesting period of stock-based awards that aregranted, modified, repurchased, or cancelled after May 1, 2006 using thegrant-date fair value of the award.  Inaddition, compensation expense is recognized for awards granted prior to, butnot yet vested as of May 1, 2006, based on the grant date fair value of theaward.  In accordance with the modifiedprospective application transition method of SFAS No. 123R, prior periodresults are not restated.  Incrementalcompensation cost for a modification of the terms or conditions of an award ismeasured by comparing the fair value of the modified award with the fair valueof the award immediately before the modification.  We have also implemented the SECinterpretations in Staff Accounting Bulletin (“SAB”) No. 107, *Share-Based Payments,*in connection with the adoption ofSFAS No. 123R.

Prior to the adoption ofSFAS No. 123R, we accounted for stock options granted to employees using theintrinsic value method under the guidance of APB No. 25, and provided pro formadisclosure as required by SFAS No. 123. No stock-based compensation cost was recognized in the statement ofoperations for the three months ended July 31, 2005 as all options granted hadan exercise price equal to the market value of our underlying common stock atthe date of grant.  Stock options issuedto non-employees were accounted for as required by SFAS No. 123.  However, no stock options were granted tonon-employees during the three months ended July 31, 2005.

We recognize compensationexpense for stock options on a straight-line basis over the requisite serviceperiod of the award.  The amount ofstock-based compensation recognized is based on the value of the portions ofthe awards that are ultimately expected to vest.  SFAS No. 123R requires forfeitures to beestimated at the time of grant and revised, if necessary, in subsequent periodsif actual forfeitures differ from those estimates.  No compensation cost is recognized forinstruments that employees forfeit because the requisite service is notrendered.  Previously recognizedcompensation cost is not reversed if an employee stock option for which therequisite service has been rendered expires unexercised.  We use historical forfeitures and employeeturnover to estimate the number of options that will actually vest.  We will reevaluate this estimate periodicallyand adjust the forfeiture rate on a prospective basis as necessary.

In accordance with themodified prospective application transition method of SFAS No. 123R, financialresults for prior periods have not been restated.  For purposes of the pro forma disclosuresrequired by SFAS No. 123, we amortized the grant-date fair value of employeestock options over the vesting period and accounted for forfeitures as theyoccurred.

See Note 4 in Item I “CondensedFinancial Statements” for additional information.

**RecentAccounting Pronouncements**

In June 2006, theFinancial Accounting Standards Board (“FASB”) issued Interpretation (“FIN”) No.48, *Accounting for Uncertainty in Income Taxes – aninterpretation of FASB Statement No. 109*.  This Interpretation prescribes a recognitionthreshold and measurement attribute for the financial statement recognition andmeasurement of a tax position taken or expected to be taken in a tax return,and provides guidance on derecognition, classification, interest and penalties,accounting in interim periods, disclosure, and transition.  This Interpretation is effective for fiscalyears beginning after December 15, 2006. We are still evaluating the impact, if any, of this Interpretation onour financial statements.

16

----

**Resultsof Operations for the Three Months Ended July 31, 2006 and 2005**

*Salesand Marketing*.  Sales and marketing expenses increasedfrom $105,217 in the three months ended July 31, 2005 to $390,682 in the threemonths ended July 31, 2006.  The $285,465increase was primarily due to an increase of $163,551 in payroll and relocationcosts, $59,703 in travel and entertainment, and $31,948 in public relations.  Stock-based compensation expense as a resultof adoption of SFAS No. 123R was $22,054 in the three months ended July 31,2006.

*Generaland Administrative*.  General and administrative expensesincreased from $763,329 in the three months ended July 31, 2005 to $2,217,613in the three months ended July 31, 2006. The $1,454,284 increase was primarily due to costs associated with aproposed public offering of our common stock that we subsequently decided not topursue.  The proposed public offering resultedin an increase of $346,479 in financial advisory consulting, $135,865 in legalservices, $111,567 in audit fees, and $130,306 in printing expenses.  In addition to the proposed public offering,the increase in general and administrative expenses was due to an increase of$181,669 in salaries, bonus, recruiting, relocation, and other payroll relatedcosts; and increases of $226,384 and $304,457 in stock-based compensation toemployees and the board of directors, respectively, as a result of adoption ofSFAS No. 123R.

*Researchand Development.*  Research and development expensesincreased from $403,225 in the three months ended July 31, 2005 to $1,588,362in the three months ended July 31, 2006. The $1,185,137 increase was primarily due to an increase of $516,457 inexternal product design and development consulting and $176,677 in test anddesign materials related to our ATRILAZETM minimally invasive system.  The increase in research and development wasalso caused by an increase of $212,357 in payroll and related costs, $105,435in stock-based compensation to employees as a result of adoption of SFAS No.123R, and $14,910 in stock-based compensation to non-employees.

*OtherIncome (Expense)*.  Other income (expense) decreased from$6,444,924 in the three months ended July 31, 2005 to $90,041 in the threemonths ended July 31, 2006.  The threemonths ended July 31, 2005 included a $6,453,938 reduction in the fair value ofthe putable warrants issued in connection with 1,803 shares of 5% Series ARedeemable Convertible Preferred Stock (“Preferred Stock”) issued on April 1,2005 discussed more fully in Note 9 of the financial statements included in ourAnnual Report on Form 10-KSB for the fiscal year ended April 30, 2006.  Interest income increased from $68,962 in thethree months ended July 31, 2005 to $108,349 in the three months ended July 31,2006.  Interest expense decreased from$79,036 in the three months ended July 31, 2005 to $37,235 in the three monthsended July 31, 2006 due to lower borrowings outstanding.

*DiscontinuedOperations.* Discontinued operations relate to the heart valve business.  The income from discontinued operations of$9,054 in the three months ended July 31, 2006 resulted from a $31,500 gain onthe disposition of fully depreciated assets offset by expenses of $22,446 inthe three months ended July 31, 2006. The loss of $102,969 in the three months ended July 31, 2005 resultedfrom heart valve sales of $338,333 offset by expenses of $441,302.

*Dividendson Preferred Stock. *Duringthe three months ended July 31, 2005, we paid cash dividends of $218,633related to the Preferred Stock.  Asdiscussed in Note 9 of our financial statements included in our Annual Reporton Form 10-KSB for the fiscal year ended April 30, 2006, these shares are nolonger outstanding.

*IncomeTax Provision*.  We have no income tax provision in thethree months ended July 31, 2006 due to the net operating losses generated forincome tax reporting purposes.  We haveestablished a valuation allowance to fully offset tax assets due to theuncertainty about our ability to generate the future taxable income necessaryto realize these deferred tax assets, particularly in light of our history ofsignificant operating losses.  In addition,future utilization of available net operating loss carryforwards may be limitedunder Internal Revenue Code Section 382 as a result of changes in ownershipthat have or may result from the issuance of common stock, redeemableconvertible preferred stock or common stock options and warrants.

17

----

**Liquidityand Capital Resources**

Cash and cash equivalentsdecreased from $10,351,570 at April 30, 2006 to $7,147,911 at July 31, 2006 dueto the following:

|                                            | ** ** | **Three months  ended July 31,  2006** | ** ** |
|--------------------------------------------|------------|-------------------------------------------------------|------------|
| Net cash used by  operating activities     |       | $                                                     | (3,158,040 | ) |
| Net cash provided by  investing activities |       | 34,153                                                |       |
| Net cash used by  financing activities     |       | (79,772                                               | )          |
| Net decrease in cash and cash equivalents  |       | $                                                     | (3,203,659 | ) |

 

*OperatingActivities. *Net cashused by operating activities was $3,158,040 in the three months ended July 31,2006 compared to $1,262,239 in the three months ended July 31, 2005.  The net cash used by operating activities of$3,158,040 in the three months ended July 31, 2006 resulted primarily from thenet loss of $4,097,562 less non-cash charges of $673,240 related to stock-basedcompensation and $262,357 in net changes in operating assets and liabilitiesprimarily due to an increase in accounts payable.  The net cash used by operating activities of$1,262,239 in the three months ended July 31, 2005 resulted primarily from thenet income of $5,070,184 less non-cash charges of $6,453,938 related to thechange in fair value of putable warrants.

*InvestingActivities. *Net cashprovided by investing activities was $34,153 for the three months ended July31, 2006 due to cash proceeds from the sales of property, plant and equipmentof $50,668 partially offset by purchases of property, plant and equipment of$16,515.  Net cash used in the three monthsended July 31, 2005 of $238,682 related to purchases of property, plant andequipment.

*FinancingActivities. *Net cashused by financing activities was $79,772 in the three months ended July 31,2006 due primarily to principal payments under our related party leaseobligation.  Net cash used by financingactivities of $253,071 in the three months ended July 31, 2005 was primarilydue to $35,563 of principal payments under our related party lease obligationand $218,633 in preferred stock dividends.

Throughout fiscal year2006 and 2005, we entered into a number of financing transactions to providefunds necessary to meet our working capital and capital expenditure needs andto meet other obligations.  Details of these activities are contained inour Annual Report on Form 10-KSB for the fiscal year ended April 30, 2006.

We expect that ouroperating losses and negative operating cash flow will continue as we continueto support the development and launch of our minimally invasive product. We anticipate that our sales and marketing, general and administrative andresearch and development expenses will continue to constitute a material use ofour cash resources.  The actual amounts and timing of our capitalexpenditures will vary significantly depending upon the progress of our productdevelopment and the availability of financing. Our cash balance of $7,147,911 at July 31, 2006 is expected to lastthrough January 2007.

Our capital requirementsmay vary depending upon the timing and the success of the implementation of ourbusiness plan, regulatory, technological and competitive developments, or if:

·              salesof our product are not achieved;

·              operatinglosses exceed our expectations;

·              ourmanufacturing and development costs or estimates prove to be inaccurate; or

·              weacquire, license or develop additional technologies.

18

----

We cannot, however,assure you that our efforts to enter the market for treating atrialfibrillation through laser ablation will:

·              beattainable;

·              beprofitable;

·              reduceour reliance upon financing transactions; or

·              enableus to continue operations.

**Commitmentsand Contingent Liabilities**

*ProductLiability Contingency.*  In March 2005, we becameaware that a patient who was utilizing our heart valve had died.  We havenot received any claims related to this matter but believe that any such claimwould be covered by our existing liability insurance.  Based upon theexpectation that insurance will cover the cost of any claims after our paymentof the deductible, we do not expect the ultimate resolution of this matter tohave a material effect on our financial position, results of operations or cashflows.

*RelatedParty Lease Obligation. * On April 4, 2003, we soldour corporate headquarters, manufacturing facility and surrounding land inInver Grove Heights, Minnesota, to PKM Properties, LLC (“PKM”), an entitycontrolled by Paul K. Miller.  Mr. Milleris one of our directors and one of the largest beneficial owners of oursecurities.  In connection with thetransaction, we received total consideration of $3.84 million consisting of(1) $1.0 million in cash, (2) PKM’s assumption of our $2.5 millionoutstanding indebtedness to Associated Bank, and (3) PKM’s assumption ofour promissory note with Dakota Electric Association and land specialassessments payable to Dakota County aggregating $336,105.

Simultaneous with thesale of the facility, we entered into a lease with PKM to lease back thefacility and a portion of the land.  Thelease has a ten-year initial term with options for us to extend the lease up toten additional years.  Under certainconditions, we also have an option to purchase the building at the end of theinitial ten-year term at the fair value at that time.

*OperatingLease.*  We have anoperating lease for a certain piece of office equipment, which expires infiscal year 2011.  At the end of theinitial lease term, we have the option to purchase the equipment at the fairmarket value, renew the lease, or return the equipment.

*SeveranceContingencies.* Employment agreements with seven officers contain a provision for lumpsum payments of up to twelve months severance if the officer is terminatedwithout cause by us or for good reason by the officer (as defined in theagreements).

*SeveranceContract.*  In April2006, we entered into an amendment to the employment agreement (the “FirstAmendment”) with John H. Jungbauer, then our Vice President, Finance and ChiefFinancial Officer, to reflect the mutual decision reached concerning Mr.Jungbauer’s departure from our company. Mr. Jungbauer’s employment ceased effective at the close of business onJuly 31, 2006.  A severance payment of$100,000 was paid on July 31, 2006 and an additional $100,000 will be paid toMr. Jungbauer in January 2007.  Inaddition to these severance payments, we have agreed to pay or reimburse Mr.Jungbauer for medical (COBRA) benefits. We recorded $94,291 in the three months ended July 31, 2006 and $131,793in fiscal year 2006 related to the severance payments, related payroll taxes,and medical benefits.

In connection with theFirst Amendment, we agreed to amend Mr. Jungbauer’s stock option agreements toprovide that his options, to the extent vested on the termination date, wouldbe exercisable for a period of twelve months following the termination of Mr.Jungbauer’s employment.  The originalterms of Mr. Jungbauer’s stock option agreements for the purchase of 144,012shares of our common stock provided that he had three months followingtermination of employment to exercise the vested portions thereof.  We accounted for the modification inaccordance with the provisions of APB No. 25 and recorded compensation expenseof $87,353 in fiscal year 2006 to reflect the intrinsic value of excess of themarket price of our stock at the date of modification over the exercise priceof the vested stock 

19

----

options.

In July 2006, we enteredinto a second amendment to the employment agreement (the “Second Amendment”)with Mr. Jungbauer to retroactively rescind the provision in the FirstAmendment that provided Mr. Jungbauer twelve months following termination ofemployment to exercise the vested portions thereof and revert to the originalterms of the stock option agreements that provide Mr. Jungbauer three monthsfollowing termination of employment to exercise the vested portionsthereof.  Options to purchase 44,065shares of our common stock had vested as of July 31, 2006.  We accounted for the subsequent modificationof the exercise period in fiscal year 2007 in accordance with the provisions ofSFAS No. 123R.  Accordingly, noincremental compensation was recorded in fiscal year 2007 as the fair value ofthe modified stock option agreements was less than the fair value immediatelybefore the modification.

*AtrialFibrillation Technology Purchase Agreement. * InAugust 2003, we entered into a technology purchase agreement with LightWaveAblation Systems, Inc. (“LightWave”) and its principals, one of whom became anemployee of our company, relating to the acquisition of LightWave’s interestsin technology consisting of a catheter/probe containing elements of opticalfiber, coolant passages and other features for the purpose of delivering laserenergy to the epicardial surface of the heart for treatment of atrialfibrillation.  We paid LightWave an initial standstill payment consistingof 1,500 shares of our common stock, $10,000 upon closing and an additional$30,000 to LightWave in installments in 2004 and 2005.  An additional$125,000 was paid to LightWave in January 2006. We will be obligated to pay an additional $385,000 within 45 days followingour achievement of $1,500,000 of cumulative gross sales of disposableproducts.  In addition, at closing, during fiscal year 2004, we issued toLightWave a warrant for the purchase of 2,500 shares of common stock at $14.60per share and, during fiscal year 2005, a warrant for the purchase of 2,500shares of common stock at $14.60 per share upon receiving FDA 510(k)clearance.  In addition, we are obligated to issue a warrant for thepurchase of 2,500 shares of common stock upon a receipt of a U.S. utilitypatent covering the product and a warrant for the purchase of 2,500 shares ofcommon stock upon the first commercial sale of our product.

Following the firstcommercial sale, we have agreed to make payments to LightWave for ten yearsequal to six percent of net sales of the LightWave product in countries inwhich we obtain patent protection and four percent of net sales of theLightWave product in territories in which there is no patent protection.  Commencing with the second year following ourfirst commercial sale, we have agreed to make minimum annual payments asfollows:

| Year Following  Commercialization | ** ** | **Minimum Annual  Payment** | ** ** |
|----------------------------------------|------------|----------------------------------|------------|
| 2                                      |       | $                                | 50,000     |   |
| 3                                      |       | 75,000                           |       |
| 4                                      |       | 100,000                          |       |
| 5                                      |       | 200,000                          |       |
| 6                                      |       | 300,000                          |       |
| 7                                      |       | 350,000                          |       |
| 8                                      |       | 350,000                          |       |
| 9                                      |       | 400,000                          |       |
| 10                                     |       | 500,000                          |       |
|                                        |            |                                  |            |  |

 

LightWave and two of itsprincipals have agreed to certain noncompetition obligations, nondisclosureobligations, and certain obligations to assign new developments or inventionsrelating to the acquired technology to our company.  We have agreed to useour reasonable commercial efforts to commercialize the technology within threeyears following the acquisition of the technology from LightWave.

If we fail in any year topay minimum annual payments, we may be obligated to grant LightWave anonexclusive right to use the technology acquired from LightWave, or payLightWave the difference between payments actually made and minimum paymentsdue for a given year.

20

----

The following tablesummarizes our contractual obligation as of July 31, 2006, excluding productliability contingencies, severance contingencies and payments that arecontingent upon achievement of future development of sales milestones, asdescribed above:
| ** **                                            | ** ** | **Payments Due By Period** | ** ** |
|-------------------------------------------------------|------------|-------------------------------------------|------------|
| **Summary of Contractual Obligations** | ** ** | **TOTAL**                                 | ** ** | **Less than One  Year** | ** ** | **Two to Three  Years** | ** ** | **Four or More  Years** | ** ** |
| Related Party Lease  Obligation(1)                    |       | $                                         | 2,805,788  |   | $ | 431,864 |   | $ | 876,379 |   | $ | 1,497,545 |   |
| Accrued Severance                                     |       | 126,084                                   |       | 126,084 |   | — |   | — |   |
| Operating Lease                                       |       | 21,197                                    |       | 5,530 |   | 11,059 |   | 4,608 |   |
| Total Contractual Obligations                         |       | $                                         | 2,953,069  |   | $ | 563,478 |   | $ | 887,438 |   | $ | 1,502,153 |   |

 

----

(1)                                  Futurepayments include interest due.

**Qualitativeand Quantitative Disclosures about Market Risk**

We are focusing all ofour resources on the development and introduction of our minimally invasivesystem.  Sales in fiscal year 2007 are not expected to be material, and weexpect that any sales will be in the United States denominated in U.S.dollars.  Our interest income and expenses are sensitive to changes in thegeneral level of U.S. interest rates, particularly since our investments are inshort-term instruments.  At July 31, 2006, we held a majority of our cashin a money market account.  Based on thecurrent nature and levels of our investments we believe that we currently haveno material market risk exposure.

Our general investingpolicy is to limit market and credit risk and the risk of principal loss. All liquid investments with maturities of three months or less are consideredto be cash equivalents.

21

----

**ITEM 3   CONTROLS AND PROCEDURES**

 

**Evaluationof Disclosure Controls and Procedures**

We maintain disclosurecontrols and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under theSecurities Exchange Act of 1934, as amended (the “Exchange Act”)) that aredesigned to ensure that information required to be disclosed by us in the reportswe file or submit under the Exchange Act is recorded, processed, summarized,and reported, within the time periods specified in the Securities and ExchangeCommission’s rules and forms, and that such information is accumulated andcommunicated to our management, including our principal executive officer andprincipal financial officer, to allow timely decisions regarding requireddisclosure.

Our management, with theparticipation of our Chief Executive Officer and Chief Financial Officer,evaluated the effectiveness of our Company’s disclosure controls and proceduresas of the end of the period covered in this Quarterly Report on Form10-QSB.  Based on this evaluation andbecause of the material weakness described below, our Chief Executive Officer andChief Financial Officer have concluded that our disclosure controls andprocedures were not effective as of the end of the period covered in thisQuarterly Report on Form 10-QSB.  Toaddress the material weakness described below, we have expanded our disclosurecontrols and procedures to include additional analysis and other proceduresover the preparation of the financial statements included in this report.  Accordingly, our management has concludedthat the financial statements included in this report fairly present in allmaterial respects our financial position, results of operations and cash flowsfor the periods presented in conformity with accounting principles generallyaccepted in the United States of America.

**Material Weakness in InternalControl Over Financial Reporting**

A material weakness is acontrol deficiency or a combination of control deficiencies that result in morethan a remote likelihood that a material misstatement of the annual or interimfinancial statements will not be prevented or detected.  Our management has concluded that, as of July31, 2006 and April 30, 2006, we did not maintain effective controls over thepreparation, review, presentation and disclosure of our financial statements.  Additionally, this control deficiency couldresult in a misstatement of the presentation and disclosure of our statement ofoperations that would result in a material misstatement in our annual orinterim financial statements that would not be prevented or detected.  Accordingly, management determined that thiscontrol deficiency constitutes a material weakness in our internal control overfinancial reporting as of July 31, 2006 and April 30, 2006.

**Changes in Internal Control OverFinancial Reporting**

There was no change inour internal control over financial reporting, other than those noted below,that occurred during our quarter ended July 31, 2006 that has materiallyaffected, or is reasonably likely to materially affect, our internal controlover financial reporting.

**Plan for Remediation of MaterialWeakness**

We have developed a planto address the above-referenced material weakness that includes addingadditional professional accounting personnel. In April 2006, we hired a full-time controller with national publicaccounting firm experience.  We willcontinue to assess the adequacy and appropriateness of our financial staff andadjust accordingly as changes in our business warrant.  Management believes that our plan to addressthis material weakness, when fully implemented, will remediate it.  Although we are not certain when the materialweakness will be remediated, we will need a period of time over which todemonstrate that these controls are functioning appropriately to conclude thatwe have adequately remediated it.

22

----

 

**PART II**

**OTHERINFORMATION**

**ITEM 1****                                LEGALPROCEEDINGS**

On March 10, 2006,J Giordano Securities LLC (d/b/a J Giordano Securities Group) (“JGSG”) filedsuit against our company in U.S. District Court for the District ofConnecticut.  JGSG, which acted as aprivate placement agent for our company in connection with sales of oursecurities to private investors in April 2005, asserts claims for breach ofcontract, unjust enrichment and quantum meruit. JGSG contends it is owed certain fees as a result of “follow ontransactions” executed by investors identified by JGSG, pursuant to theengagement agreement, as amended, between us and JGSG or, in the alternative,that it should be awarded such fees on an equitable basis.  In particular, JGSG claims that the exerciseof outstanding warrants for the purchase of common stock by certainJGSG-identified investors and our purchase of outstanding shares of 5% Series ARedeemable Convertible Preferred Stock from certain JGSG-identified investorsin December 2005 and January 2006 entitle JGSG to damages no less than$1,431,769.  JGSG seeks (a) $279,191 incash commissions, (b) warrants for the purchase of 85,905 shares at $3.25 pershare, (c) lost profits of $751,669 on the argument that JGSG would haveexercised the foregoing warrant and sold 85,905 shares on December 30, 2005, ata price of $12.00 per share, and (d) the $400,909 in cash commissions we paidC.E. Unterberg, Towbin, LLC.  JGSG alsoseeks reimbursement for reasonable expenses, interest, costs and attorneys’fees.  The U.S. District Court for theDistrict of Connecticut has referred the matter to NASD arbitration; however,there remains a motion to determine the venue of the NASD arbitration pendingbefore the federal court.

On May 26, 2006,JGSG notified us by letter that, pursuant to the agreement, it may claimcompensation arising out of alleged rights to serve as a co-managingunderwriter or member of the underwriting group of a proposed public offeringset forth in the registration statement on Form SB-2 we filed with theSecurities and Exchange Commission on May 19, 2006.  Due to market conditions, we requested awithdrawal of such registration statement on August 9, 2006.

We believe thatthis lawsuit is without merit and intend to vigorously defend ourselves.

**ITEM 6****                                EXHIBITS**

See “Index toExhibits.”

23

----

**SIGNATURES**

In accordance with therequirements of the Exchange Act, the registrant caused this report to besigned on its behalf by the undersigned, thereunto duly authorized.
|                               | MedicalCV, Inc. |
|-------------------------------|----------------------|
|                          |                 |
|                          |                 |
| Date: September 13, 2006 | By                   | /s/ Marc P. Flores |   |
|                          |                 | Marc P. Flores |
|                          |                 | President and Chief Executive Officer |
|                          |                 |
|                          | By                   | /s/ Eapen Chacko |   |
|                          |                 | Eapen Chacko |
|                          |                 | Vice President, Finance and  Chief Financial Officer |
|                               |                      |  |  |  |  |  |  |

 

24

----

**INDEX TO EXHIBITS**
|  Exhibit  Number | ** ** | **Description**                                                                                                                                                                                                                                |
|-----------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                  |       |                                                                                                                                                                                                                                           |
| 3.1                   |       | Restated Articles of Incorporation of the  Registrant, as Amended (incorporated by reference to Amendment No. 1 to our  Registration Statement on Form SB-2, filed on June 6, 2006 (File No.  333-134315)).                                    |
|                  |       |                                                                                                                                                                                                                                           |
| 3.2                   |       | Bylaws of the Registrant (incorporated by reference  to our Registration Statement on Form SB-2, filed on August 31, 2001 (File  No. 333-68884)).                                                                                              |
|                  |       |                                                                                                                                                                                                                                           |
| 4.1                   |       | Reference is made to Exhibits 3.1 and 3.2.                                                                                                                                                                                                     |
|                  |       |                                                                                                                                                                                                                                           |
| 4.2                   |       | Specimen Common Stock Certificate (incorporated by  reference to Amendment No. 1 to our Registration Statement on Form SB-2,  filed on June 6, 2006 (File No. 333-134315)).                                                                    |
|                  |       |                                                                                                                                                                                                                                           |
| 10.1                  |       | Restated Executive Employment Agreement, effective  May 30, 2006, by and between MedicalCV, Inc. and Eapen Chacko (incorporated  by reference to our Current Report on Form 8-K filed on June 5, 2006 (File  No. 000-33295)).                  |
|                  |       |                                                                                                                                                                                                                                           |
| 10.2                  |       | Second Amendment to Executive Employment Agreement  by and between John H. Jungbauer and MedicalCV, Inc., dated July 18, 2006  (incorporated by reference to our Current Report on Form 8-K filed on July  20, 2006 (File No. 000-33295)).     |
|                  |       |                                                                                                                                                                                                                                           |
| 10.3                  |       | Form of Non-Qualified Stock Option Agreement issued  to Directors under Amended and Restated 2001 Equity Incentive Plan (incorporated  by reference to our Annual Report on Form 10-KSB filed on July 20, 2006 (File  No. 000-33295)).         |
|                  |       |                                                                                                                                                                                                                                           |
| 10.4                  |       | Form of Non-Qualified Stock Option Agreement under  the MedicalCV, Inc. 2001 Equity Incentive Plan issued to Executive Officers  (incorporated by reference to our Annual Report on Form 10-KSB filed on July  20, 2006 (File No. 000-33295)). |
|                  |       |                                                                                                                                                                                                                                           |
| 31.1                  |       | Chief Executive Officer Certification pursuant to  Exchange Act Rule 13a-14(a).                                                                                                                                                           |
|                  |       |                                                                                                                                                                                                                                           |
| 31.2                  |       | Chief Financial Officer Certification pursuant to  Exchange Act Rule 13a-14(a).                                                                                                                                                           |
|                  |       |                                                                                                                                                                                                                                           |
| 32.1                  |       | Chief Executive Officer Certification pursuant to 18  U.S.C. Section 1350.                                                                                                                                                                |
|                  |       |                                                                                                                                                                                                                                           |
| 32.2                  |       | Chief Financial Officer Certification pursuant to 18  U.S.C. Section 1350.                                                                                                                                                                |

 

25

----