UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C. 20549





FORM
10-Q







x
            QUARTERLY
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934




FOR
THE QUARTERLY PERIOD ENDED MARCH 31, 2010




or




 ̈
            TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934




Commission
File No. 000-30335







OTIX
GLOBAL, INC.


(Exact
name of registrant as specified in its charter)









DELAWARE
                87-0494518(State
      or other jurisdiction of
                  incorporation
      or organization)
                (I.R.S.
      Employer
                  Identification
      No.)


4246
South Riverboat Road, Suite 300


Salt
Lake City, UT 84123


(Address
of principal executive offices)




(801)
312-1700


(Registrant’s
telephone number, including area code)







Indicate
by check mark whether the registrant: (1) has filed all reports required to
be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934
during the preceding 12 months (or for such 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.    x  Yes     ̈  No




Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this
chapter) during the preceding 12 months (or for such shorter period that the
registrant was required to submit and post such
files).     ̈  Yes     ̈  No




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




Large accelerated filer
                   ̈
                  Accelerated
      filer
                   ̈Non-accelerated
      filer
                  x
                  Smaller reporting company
                   ̈




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




As of May
4, 2010, there were 5,573,517 shares of the registrant’s $0.005 par value common
stock outstanding.





OTIX
GLOBAL, INC.


TABLE
OF CONTENTS




PagePART
      I. FINANCIAL INFORMATIONITEM 1.
                      Condensed
      Consolidated Financial Statements (Unaudited):Condensed
      Consolidated Balance Sheets as of March 31, 2010 and December 31,
      2009
                      
                      
                      3Condensed
      Consolidated Statements of Operations for the Three Months EndedMarch
      31, 2010 and 2009
                      
                      
                      4Condensed
      Consolidated Statements of Cash Flows for the Three Months Ended March 31,
      2010 and 2009
                      
                      
                      5Notes
      to Condensed Consolidated Financial Statements
                      
                      
                      6ITEM 2.
                      Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
                      
                      
                      15ITEM 3.
                      Quantitative
      and Qualitative Disclosures about Market Risks
                      
                      
                      24ITEM 4.
                      Controls
      and Procedures
                      
                      
                      25PART
      II. OTHER INFORMATIONITEM 1.
                      Legal
      Proceedings
                      
                      
                      25ITEM 1A.
                      Risk
      Factors
                      
                      
                      25ITEM
      4.
                      Reserved
                      
                      
                      26ITEM 6.
                      Exhibits
                      
                      
                      26SIGNATURE
                      
                      
                      27CERTIFICATIONS


2


PART
I. FINANCIAL INFORMATION




ITEM 1.
            CONDENSED
      CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)




OTIX
GLOBAL, INC.




CONDENSED
CONSOLIDATED BALANCE SHEETS


(in
thousands, except per share data)


(unaudited)




March
      31,
                
                
                December 31,2010
                
                
                2009ASSETSCurrent
      assets:Cash
      and cash equivalents
                
                $
                12,338
                
                
                $
                12,154Restricted
      cash
                
                
                74
                
                
                
                71Accounts
      receivable, net of allowance for doubtful accounts of $862 and
      $851
                
                
                10,048
                
                
                
                10,625Inventories
                
                
                9,791
                
                
                
                8,754Prepaid
      expenses and other
                
                
                3,903
                
                
                
                4,315Total
      current assets
                
                
                36,154
                
                
                
                35,919Property
      and equipment, net of accumulated depreciation and amortization of $20,620
      and $19,941
                
                
                8,792
                
                
                
                8,755Definite-lived
      intangible assets, net
                
                
                2,879
                
                
                
                3,016Indefinite-lived
      intangible assets
                
                
                9,661
                
                
                
                9,368Goodwill
                
                
                7,380
                
                
                
                7,772Other
      assets
                
                
                2,212
                
                
                
                2,295Total
      assets
                
                $
                67,078
                
                
                $
                67,125LIABILITIES
      AND SHAREHOLDERS’ EQUITYCurrent
      liabilities:Current
      portion of long-term debt
                
                $
                6,658
                
                
                $
                4,923Accounts
      payable
                
                
                7,625
                
                
                
                6,426Accrued
      payroll and related expenses
                
                
                4,349
                
                
                
                4,515Accrued
      restructuring
                
                
                135
                
                
                
                356Accrued
      warranty
                
                
                3,956
                
                
                
                3,901Deferred
      revenue
                
                
                4,696
                
                
                
                4,602Other
      accrued liabilities
                
                
                3,479
                
                
                
                3,602Total
      current liabilities
                
                
                30,898
                
                
                
                28,325Long-term
      debt, net of current portion
                
                
                159
                
                
                
                452Deferred
      revenue, net of current portion
                
                
                4,574
                
                
                
                5,264Other
      liabilities
                
                
                230
                
                
                
                282Total
      liabilities
                
                
                35,861
                
                
                
                34,323Commitments
      and contingencies (Notes 3 and 4)Shareholders’
      equity:Preferred
      stock, $0.001 par value; 5,000 shares authorized; zero issued and
      outstanding
                
                
                -
                
                
                
                -Common
      stock, $0.005 par value; 14,000 shares authorized; 5,767 and 5,762 shares
      issued and outstanding, respectively
                
                
                29
                
                
                
                29Additional
      paid-in-capital
                
                
                145,664
                
                
                
                145,359Accumulated
      deficit
                
                
                (120,577
                )
                
                
                (118,244
                )Accumulated
      other comprehensive income
                
                
                9,874
                
                
                
                9,431Treasury
      stock; 195 shares at cost
                
                
                (3,773
                )
                
                
                (3,773
                )Total
      shareholders’ equity
                
                
                31,217
                
                
                
                32,802Total
      liabilities and shareholders’ equity
                
                $
                67,078
                
                
                $
                67,125




See
accompanying notes to condensed consolidated financial
statements.


3




OTIX
GLOBAL, INC.




CONDENSED
CONSOLIDATED STATEMENTS OF OPERATIONS


(in
thousands, except per share data)


(unaudited)




Three months ended March 31,2010
                      
                      
                      2009Net
      sales
                      
                      $
                      20,777
                      
                      
                      $
                      24,432Cost
      of sales
                      
                      
                      7,461
                      
                      
                      
                      10,269Gross
      profit
                      
                      
                      13,316
                      
                      
                      
                      14,163Selling,
      general and administrative expense
                      
                      
                      14,743
                      
                      
                      
                      14,321Research
      and development expense
                      
                      
                      1,065
                      
                      
                      
                      1,979Goodwill
      and definite-lived intangibles impairment charges
                      
                      
                      -
                      
                      
                      
                      14,658Restructuring
      credit
                      
                      
                      (20
                      )
                      
                      
                      -Operating
      loss
                      
                      
                      (2,472
                      )
                      
                      
                      (16,795
                      )Interest
      expense
                      
                      
                      (51
                      )
                      
                      
                      (140
                      )Other
      income, net
                      
                      
                      25
                      
                      
                      
                      108Loss
      before income taxes
                      
                      
                      (2,498
                      )
                      
                      
                      (16,827
                      )Provision
      (benefit) for income taxes
                      
                      
                      (172
                      )
                      
                      
                      96Loss
      from continuing operations
                      
                      
                      (2,326
                      )
                      
                      
                      (16,923
                      )Loss
      from discontinued operations, net of income taxes
                      
                      
                      (7
                      )
                      
                      
                      (45
                      )Net
      loss
                      
                      $
                      (2,333
                      )
                      
                      $
                      (16,968
                      )Basic
      and diluted loss per common share:Continuing
      operations
                      
                      $
                      (0.42
                      )
                      
                      $
                      (3.07
                      )Discontinued
      operations
                      
                      
                      -
                      
                      
                      
                      (0.01
                      )Net
      loss
                      
                      $
                      (0.42
                      )
                      
                      $
                      (3.08
                      )Weighted
      average number of common shares outstanding:Basic
                      
                      
                      5,570
                      
                      
                      
                      5,517Diluted
                      
                      
                      5,570
                      
                      
                      
                      5,517




See
accompanying notes to condensed consolidated financial
statements.


4


OTIX
GLOBAL, INC.




CONDENSED
CONSOLIDATED STATEMENTS OF CASH FLOWS


(in
thousands)


(unaudited)




For
      the three months ended
                      March
      31,2010
                    
                    
                    2009Cash
      flows from operating activities:Net
      loss
                    
                    $
                    (2,333
                    )
                    
                    $
                    (16,968
                    )Loss
      from discontinued operations, net of income taxes
                    
                    
                    7
                    
                    
                    
                    45Adjustments
      to reconcile net loss to net cash provided by (used in) operating
      activities:Depreciation
      and amortization
                    
                    
                    843
                    
                    
                    
                    1,047Stock-based
      compensation
                    
                    
                    305
                    
                    
                    
                    468Foreign
      currency loss, net
                    
                    
                    351
                    
                    
                    
                    200Deferred
      income taxes
                    
                    
                    (18
                    )
                    
                    
                    13Amortization
      of interest on long-term debt
                    
                    
                    1
                    
                    
                    
                    46Goodwill
      and definite-lived intangible impairment charges
                    
                    
                    -
                    
                    
                    
                    14,658Loss
      on disposal of long-lived assets
                    
                    
                    20
                    
                    
                    
                    -Changes
      in assets and liabilities:Accounts
      receivable
                    
                    
                    394
                    
                    
                    
                    905Inventories
                    
                    
                    (1,084
                    )
                    
                    
                    (1,477
                    )Other
      assets
                    
                    
                    (36
                    )
                    
                    
                    126Withholding
      taxes remitted on share-based awards
                    
                    
                    (7
                    )
                    
                    
                    (29
                    )Accrued
      restructuring
                    
                    
                    (221
                    )
                    
                    
                    (189
                    )Accounts
      payable, accrued expenses and deferred revenue
                    
                    
                    802
                    
                    
                    
                    1,195Net
      cash provided by (used in) operating activities from continuing
      operations
                    
                    
                    (976
                    )
                    
                    
                    40Net
      cash provided by (used in) discontinued operations
                    
                    
                    (36
                    )
                    
                    
                    94Net
      cash provided by (used in) operating activities
                    
                    
                    (1,012
                    )
                    
                    
                    134Cash
      flows from investing activities:Purchase
      of property and equipment
                    
                    
                    (647
                    )
                    
                    
                    (738
                    )Payment
      for technology license
                    
                    
                    (54
                    )
                    
                    
                    -Customer
      loan repayments (advances), net
                    
                    
                    611
                    
                    
                    
                    (496
                    )Net
      cash used in investing activities
                    
                    
                    (90
                    )
                    
                    
                    (1,234
                    )Cash
      flows from financing activities:Proceeds
      from exercise of stock options and tax collected on vesting of restricted
      stock awards
                    
                    
                    7
                    
                    
                    
                    20Borrowings
      on line of credit
                    
                    
                    3,000
                    
                    
                    
                    -Repayments
      on line of credit
                    
                    
                    (971
                    )
                    
                    
                    -Proceeds
      from maturity of restricted cash, cash equivalents and marketable
      securities
                    
                    
                    -
                    
                    
                    
                    (64
                    )Principal
      payments on long-term debt
                    
                    
                    (596
                    )
                    
                    
                    (2,152
                    )Net
      cash provided by (used in) financing activities
                    
                    
                    1,440
                    
                    
                    
                    (2,196
                    )Effect
      of exchange rate changes on cash and cash equivalents from continuing
      operations
                    
                    
                    (153
                    )
                    
                    
                    (192
                    )Effect
      of exchange rate changes on cash and cash equivalents from discontinued
      operations
                    
                    
                    (1
                    )
                    
                    
                    (15
                    )Effect
      of exchange rate changes on cash and cash equivalents
                    
                    
                    (154
                    )
                    
                    
                    (207
                    )Net
      increase (decrease) in cash and cash equivalents
                    
                    
                    184
                    
                    
                    
                    (3,503
                    )Cash
      and cash equivalents, beginning of the period
                    
                    
                    12,154
                    
                    
                    
                    13,129Cash
      and cash equivalents, end of the period
                    
                    $
                    12,338
                    
                    
                    $
                    9,626Supplemental
      cash flow information:Cash
      paid for interest expense, net of amount capitalized
                    
                    $
                    90
                    
                    
                    $
                    110Cash
      paid for income taxes
                    
                    
                    79
                    
                    
                    
                    360




See
accompanying notes to condensed consolidated financial
statements.


5


OTIX
GLOBAL, INC.




NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


(in
thousands, except per share data)


(unaudited)




1.
BASIS OF PRESENTATION




The
accompanying unaudited condensed consolidated financial statements have been
prepared in accordance with U.S. generally accepted accounting principles for
interim financial information and with the instructions to Form 10-Q and Rule
10-01 of Regulation S-X. Accordingly, they do not include all of the information
and footnotes required by U.S. generally accepted accounting principles for
complete financial statements. In the opinion of management, all adjustments
(consisting only of normal recurring adjustments) considered necessary for a
fair statement have been included. The results of operations for the three
months ended March 31, 2010 are not necessarily indicative of results that
may be expected for the full year ending December 31, 2010. For further
information, refer to the consolidated financial statements and footnotes
thereto included in the Otix Global, Inc. Annual Report on Form 10-K for the
year ended December 31, 2009 as filed with the U.S. Securities and Exchange
Commission (“SEC”).




On
September 1, 2008, the Company sold one European operation and closed a
second European operation. As of March 31, 2010 and December 31, 2009, there
were no material balances related to these operations remaining in the Condensed
Consolidated Balance Sheets. These operations have been classified as
discontinued operations in the Condensed Consolidated Statements of Operations
and the Condensed Consolidated Statements of Cash Flows for the three months
ended March 31, 2010 and 2009.




On March
12, 2010, Company management implemented the Board of Directors’ approval of a
reverse stock split at a 1-for-5 ratio, which was effective as of March 29,
2010. The shareholders had approved the reverse stock split on May 7,
2009.  As a result of the reverse stock split, every 5 shares of the
Company’s common stock that were issued as of March 29, 2010 were combined into
one issued and outstanding share, with a change in the par value of such shares
from $0.001 to $0.005 per share, subject to the elimination of fractional
shares. The reverse stock split has been retroactively applied to all periods
presented.




As
further discussed in Note 2, in June 2009, the German government passed a law
that became effective April 1, 2009. The key implication to the Company’s
business model was to impose additional costs on the doctors and insurance
companies that conduct business with the Company’s German subsidiary. The
Company is currently renegotiating contracts in light of the new legislative
requirements and is working to contract with other insurance companies as well.
The lack of signed contracts, the imposition of new and costly requirements on
the ENT doctors and insurance companies, as well as the uncertainty of
regulatory requirements, make the long term prospects for the Company's German
subsidiary uncertain. Final regulatory requirements are expected to be completed
during the second quarter 2010, the impact of which is unknown at this
time.




The
Company’s ability to make payments on and to refinance its indebtedness, and to
fund planned capital expenditures and ongoing operations, will depend on its
ability to generate cash in the future. This depends to a degree on general
economic, financial, competitive, legislative, regulatory and other factors that
are beyond the Company’s control. The Company plans to continue to manage
its receivables and inventory, and together with available cash balances;
it is expected to be able to fund future debt service payments, ongoing
operations, and capital expenditures through at least December 31,
2010. Considering its current level of operations, expected revenue growth
and anticipated cost management and operating improvements, the Company plans on
generating cash flow from operations in the latter part of 2010. The key to this
plan will be its German operating performance. It expects that total current
debt service payments due over the next year will be repaid from available
cash on hand, and anticipated cash flow from operations. The Company has
negotiated an extension on its line of credit (See Note 3 for further
details).




There can
be no assurance, however, that the Company’s business will generate sufficient
cash flow from operations, that currently anticipated cost savings and operating
improvements will be realized on schedule or that future borrowings will be
available in an amount sufficient to enable it to pay its indebtedness or to
fund other liquidity needs. Furthermore, the Company cannot provide any
assurances that ongoing uncertainty in global capital markets and general
economic conditions will not have a material adverse impact on its future
operations and cash flows. The Company may need to refinance all or a
portion of its indebtedness on or before maturity and it cannot provide
assurances that it will be able to refinance any of its indebtedness on
commercially reasonable terms, or at all. Should the Company be unable to
renegotiate its debt service payments, it may need to sell assets of the
company, which will also be subject to market conditions existing at that time.
Both the revolving credit facility and the German bank debt have a customary
material adverse change clause that allows the banks to call the loans, if
invoked. Neither bank has invoked this clause. The Company is in compliance with
its debt covenants as of March 31, 2010. As of March 31, 2010, the Company’s
outstanding borrowings of $5,145 on the line of credit represented the maximum
allowable borrowing under the terms of the agreement.


6




The
Company monitors its capital structure on an ongoing basis and from time to time
considers financing and refinancing options to improve its capital structure and
to enhance its financial flexibility. The ability to enter into new financing
arrangements is subject to restrictions in the Company’s outstanding debt
instruments. At any given time the Company may pursue a variety of financing
opportunities, and its decision to proceed with any financing will depend, among
other things, on prevailing market conditions, near term maturities and
available terms.




Principles of Consolidation.The condensed consolidated financial statements include the accounts of
Otix and its wholly owned subsidiaries. Intercompany balances and transactions
are eliminated in consolidation.




Use of Estimates.The
preparation of financial statements in conformity with U.S. generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities as of the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period. The
most significant estimates affecting the financial statements are those related
to allowance for doubtful accounts, sales returns, inventory obsolescence,
goodwill, long-lived asset impairment, warranty accruals, legal contingency
accruals and deferred income tax asset valuation allowances. Actual results
could differ from those estimates.




Revenue Recognition.Sales of
hearing aids are recognized when (i) products are shipped, except for
retail hearing aid sales, which are recognized upon acceptance by the consumer,
(ii) persuasive evidence of an arrangement exists, (iii) title and
risk of loss has transferred, (iv) the price is fixed or determinable,
(v) contractual obligations have been satisfied, and
(vi) collectibility is reasonably assured. Revenues related to sales of
separately priced extended service contracts are deferred and recognized on a
straight-line basis over the contractual periods. Deferred revenue also includes
cash received prior to revenue recognition criteria being met (for example,
customer acceptance). Net sales consist of product sales less provisions for
sales returns and rebates, which are made at the time of sale. The Company
generally has a 60 day return policy for wholesale and 30 days for retail
hearing aid sales, and allowances for sales returns are reflected as a reduction
of sales and accounts receivable. If actual sales returns differ from the
Company’s estimates, revisions to the allowance for sales returns will be
required. Allowances for sales returns were as follows:





ThreemonthsendedMarch31,2010
                  
                  
                  2009Balance,
      beginning of period
                  
                  $
                  1,196
                  
                  
                  $
                  1,994Provisions
                  
                  
                  1,275
                  
                  
                  
                  2,307Returns
      processed
                  
                  
                  (1,301
                  )
                  
                  
                  (2,231
                  )Balance,
      end of period
                  
                  $
                  1,170
                  
                  
                  $
                  2,070




For the
three months ended March 31, 2010 and 2009, the Australian Government’s Office
of Hearing Services, a division of the Department of Health and Aging, accounted
for approximately 20% and 12% of the Company’s total net sales, respectively. No
other customer accounted for 10% or more of consolidated sales. No single
customer comprised more than 10% of accounts receivable as of March 31,
2010 and 2009.




Taxes Collected from Customers and
Remitted to Governmental Authorities.The Company recognizes taxes
assessed by a governmental authority that are directly imposed on a
revenue-producing transaction between a seller and a customer on a net basis
(excluded from net sales).




Warranty Costs.The Company
provides for the cost of remaking and repairing products under warranty at the
time of sale, typically for periods of six months to three years depending upon
customer, product and geography. These costs are included in cost of sales. When
evaluating the adequacy of the warranty reserve, the Company analyzes the amount
of historical and expected warranty costs by geography, by product family, by
model and by warranty period as appropriate. If actual product failure rates or
repair and remake costs differ from the Company’s estimates, revisions to the
warranty accrual will be required.




Accrued
warranty costs were as follows:





ThreemonthsendedMarch31,2010
                  
                  
                  2009Balance,
      beginning of period
                  
                  $
                  3,901
                  
                  
                  $
                  3,727Provisions
                  
                  
                  913
                  
                  
                  
                  735Costs
      incurred
                  
                  
                  (858
                  )
                  
                  
                  (890
                  )Balance,
      end of period
                  
                  $
                  3,956
                  
                  
                  $
                  3,572





Cash Equivalents. The Company
considers all short-term investments purchased with an original maturity of
three months or less to be cash equivalents. As of March 31, 2010 and
December 31, 2009, cash equivalents consisted of money market funds
totaling $2,461 and $4,860, respectively. As of March 31, 2010 and
December 31, 2009, the Company had pledged $74 and $71 of cash and cash
equivalents, respectively, as a security deposit for banking
arrangements.


7





Fair Value Measurements.We
account for financial assets and liabilities, and applicable non-financial
assets and non-financial liabilities according to ASC 820, “Fair Value Measurements and
Disclosures.” ASC 820 defines fair value, establishes a framework for
measuring fair value under generally accepted accounting principles and enhances
disclosures about fair value measurements. Fair value is defined as the exchange
price that would be received for an asset or paid to transfer a liability (an
exit price) in the principal or most advantageous market for the asset or
liability in an orderly transaction between market participants on the
measurement date. Valuation techniques used to measure fair value must maximize
the use of observable inputs and minimize the use of unobservable inputs. The
standard describes a fair value hierarchy based on three levels of inputs, of
which the first two are considered observable and the last unobservable, that
may be used to measure fair value which are the following:




•
            Level
      1 - Quoted prices in active markets for identical assets or
      liabilities.




•
            Level
      2 - Inputs other than Level 1 that are observable, either directly or
      indirectly, such as quoted prices for similar assets or liabilities;
      quoted prices in markets that are not active; or other inputs that are
      observable or can be corroborated by observable market data for
      substantially the full term of the assets or
  liabilities.




•
            Level
      3 - Unobservable inputs that are supported by little or no market activity
      and that are significant to the fair value of the assets or
      liabilities.




The
Company’s money market funds totaling $2,461 as of March 31, 2010 are
recorded at fair value using Level 1 observable inputs.




Derivative Instruments and Hedging
Activities. The Company follows ASC 815, “Derivatives and Hedging,” for
its derivative and hedging activities and related disclosures.




The
Company may enter into readily marketable forward contracts with financial
institutions to minimize the short-term impact of foreign currency fluctuations
on certain intercompany balances. The Company has not designated its contracts
as hedging instruments, nor does the Company enter into contracts for trading or
speculation purposes. Gains and losses on the contracts are included in the
results of operations and offset foreign exchange gains or losses recognized on
the revaluation of certain intercompany balances. The Company’s foreign exchange
forward contracts generally mature in three months or less from the contract
date. The Company entered into a foreign currency forward contract during the
three months ended March 31, 2010 and the Company recorded a $322 gain in Other
income, net in the Condensed Consolidated Statements of Operations for the
quarter ending March 31, 2010.  The contracts expired on March 31,
2010. The Company held forward contract hedges on €3,800 ($5,135) and Australian
$500 ($457) at March 31, 2010. As of March 31, 2010, the Company
recognized an unrealized loss of $4 in connection with its foreign currency
forward contracts. The unrealized loss is recorded in Other income, net in the
Condensed Consolidated Statements of Operations, and in Prepaid expenses and
other in the Condensed Consolidated Balance Sheets. The contracts will expire in
the second quarter of 2010. Effective in the second quarter 2008, the Company
entered into an interest rate swap agreement which effectively fixed the
interest rate of the long term debt associated with the German acquisition at
9.59% (see Note 3 for further details).




Inventories.Inventories are
stated at the lower of cost or market using the first-in, first-out method. The
Company includes material, labor and manufacturing overhead in the cost of
inventories. Provision is made (i) to reduce excess and obsolete
inventories to their estimated net realizable values and (ii) for estimated
product (inventory) returns in those countries that sell on a retail basis and
recognize a sale only upon acceptance by the consumer. Once the value is
adjusted, the original cost less the inventory write-down represents the new
cost basis. Amounts are written off and the associated reserve is reversed when
the related inventory has been scrapped or sold. Inventories, net of reserves
consisted of the following:




March31,
                    2010
                  
                  
                  December31,
                    2009Raw
      materials and components
                  
                  $
                  4,368
                  
                  
                  $
                  3,410Work
      in progress
                  
                  
                  95
                  
                  
                  
                  55Finished
      goods
                  
                  
                  5,328
                  
                  
                  
                  5,289Total
                  
                  $
                  9,791
                  
                  
                  $
                  8,754


8




Comprehensive Loss.Comprehensive loss includes net loss plus the results of certain changes
in shareholders’ equity that are not reflected in the results of operations.
Comprehensive loss consisted solely of changes in foreign currency translation
adjustments, which were not adjusted for income taxes as they related to
specific indefinite investments in foreign subsidiaries and net
loss.




ThreemonthsendedMarch31,2010
                  
                  
                  2009Net
      loss
                  
                  $
                  (2,333
                  )
                  
                  $
                  (16,968
                  )Foreign
      currency translation gain (loss)
                  
                  
                  443
                  
                  
                  
                  (1,419
                  )Comprehensive
      loss
                  
                  $
                  (1,890
                  )
                  
                  $
                  (18,387
                  )




Share-Based Compensation.Share-based compensation cost is measured at the grant date, based on the
fair value of the award and is recognized over the employee requisite service
period. For further information, refer to the footnotes included in the
Company’s Annual Report on Form 10-K for the year ended December 31, 2009
as filed with the SEC.




Share-based
compensation expense pertaining to stock options and restricted stock awards was
$305 and $468 for the three months ended March 31, 2010 and 2009, respectively.
Share-based compensation expense of $55 and $52 was recorded in cost of sales,
$194 and $342 in selling general and administrative expense and $56 and $74 in
research and development expense for the three months ended March 31, 2010 and
2009, respectively.




During
the three months ended March 31, 2010, the Company granted 12 stock option
awards with an aggregate fair value of $30. The fair value of the options issued
during the three months ended March 31, 2010 was estimated on the date of
grant based on a risk free rate of return of 2.6%, an expected dividend yield of
0.0%, volatility of 62.5%, and an expected life of 5 years. The Company did not
grant any stock option awards during the three months ended March 31,
2009.




During
the three months ended March 31, 2010 and 2009, the Company did not grant any
restricted stock awards.




As of
March 31, 2010, there was $876 and $1,065 of unrecognized share-based
compensation expense relating to options and restricted stock awards,
respectively, that will be recognized over a weighted-average period of 2.5 and
3.0 years, respectively.




Loss Per Common Share. Basic
loss per common share is calculated based upon the weighted average shares of
common stock outstanding during the period. Diluted loss per share is calculated
based upon the weighted average number of shares of common stock outstanding,
plus the dilutive effect of common stock equivalents calculated using the
treasury stock method. Dilutive common stock equivalents for the three months
ended March 31, 2010 consisted of 29 equivalent shares pertaining to 139 stock
shares. Antidilutive common stock equivalents of 701 shares for the three months
ended March 31, 2010 were excluded from the diluted loss per share calculation.
Antidilutive common stock equivalents of 813 shares for the three months ended
March 31, 2009 were excluded from the diluted loss per share
calculation.




Income Taxes.In some
jurisdictions net operating loss carry-forwards reduce or offset tax provisions.
The Company’s income tax provision (benefit) for the three months ended March
31, 2010 and 2009 was ($172) and $96, respectively. The current year income tax
provision was principally the result of pre-tax losses in certain foreign
geographies, alternative minimum tax in the U.S., and state taxes. Income taxes
on profits in the U.S. and a number of the Company’s foreign subsidiaries are
currently negated by its net operating loss carry-forwards.




Recent Accounting
Pronouncements.




ASU
2009-13, “Revenue Recognition
(ASU Topic 605) – Multiple Deliverable Revenue Arrangements”, a consensus
of the FASB Emerging Issues Task Force which is effective for the Company in the
first quarter of fiscal year 2011, with early adoption permitted, modifies the
fair value requirements of ASC subtopic 605-25, “Revenue Recognition-Multiple
Element Arrangements”, by allowing the use of the “best estimate of
selling price” in addition to vendor-specific objective evidence (“VSOE”) and
verifiable objective evidence (“VOE”) (now referred to as “TPE” standing for
third-party evidence) for determining the selling price of a deliverable. A
vendor is now required to use its best estimate of the selling price when VSOE
or TPE of the selling price cannot be determined. In addition, the residual
method of allocating arrangement consideration is no longer permitted. In
October 2009, the FASB also issued ASU 2009-14, “Software (ASC Topic 985) –
Certain Revenue Arrangements That Include Software Elements”,a consensus
of the FASB Emerging Issues Task Force. This guidance modifies the scope of ASC
subtopic 965-605, “Software-Revenue Recognition”,to exclude from its requirements (a) non-software components of
tangible products and (b) software components of tangible products that are
sold, licensed, or leased with tangible products when the software components
and non-software components of the tangible product function together to deliver
the tangible product’s essential functionality. This update requires expanded
qualitative and quantitative disclosures once adopted. The Company is currently
evaluating the impact of adopting these pronouncements and does not expect the
standard to have a material impact on its condensed consolidated financial
statements.


9




2.
INTANGIBLE ASSETS




In
accordance with the ASC 360-10, “Property, Plant and Equipment”,long-lived assets such as property, plant, and equipment, and purchased
intangible assets subject to amortization, are amortized over their respective
estimated useful lives and are reviewed for impairment whenever events or
changes in circumstances indicate that the carrying amount of an asset or asset
group may not be recoverable. Recoverability of assets to be held and used is
measured by a comparison of the carrying amount of an asset or asset group to
estimated undiscounted future cash flows expected to be generated by the asset
or asset group. If the carrying amount of an asset or asset group exceeds its
estimated future cash flows, an impairment charge is recognized in the amount by
which the carrying amount of the asset exceeds the fair value of the asset or
asset group. The Company performs its annual impairment test in December or when
a triggering event has occurred.  There were no triggering events
during the first three months of 2010.




Goodwill
represents the excess of the cost of businesses acquired over the fair value of
the assets acquired and liabilities assumed. In accordance with the provisions
of ASC 350, “Intangibles-
Goodwill and Other”, the Company does not amortize goodwill, but tests it
for impairment annually using a fair value approach at the “reporting unit”
level. In accordance with ASC 350, a reporting unit is the operating segment, or
a business one level below an operating segment (the “component” level) if
discrete financial information is prepared and regularly reviewed by senior
management. However, components are aggregated as a single reporting unit if
they have similar economic characteristics.




Goodwill
and intangible assets that have indefinite useful lives are tested annually for
impairment at year end, or more frequently if impairment indicators are present.
Such indicators of impairment include, but are not limited to, changes in
business climate, and operating or cash flow losses related to such assets. To
measure the amount of an impairment loss, the standard prescribes a two-step
method. The first step requires the Company to determine the fair value of the
reporting unit and compare that fair value to the net book value of the
reporting unit. The fair value of the reporting unit is determined using the
income approach (discounted cash flow analysis). Under the income approach, the
fair value of the asset is based on the value of the estimated cash flows that
the asset can be expected to generate in the future. These estimated cash flows
were discounted at a rate of 16.0% to arrive at the fair values in the Company’s
2009 calculations. The Company also considers market information (market
approach) when such information is available to validate the more detailed
discounted cash flow calculations. Market information typically includes the
Company’s general knowledge of sale transaction multiples and/or previous
discussions the Company has had with third parties regarding the value of a
similar reporting unit or the Company’s specific reporting unit. The Company
relies principally on the income approach because it reflects the reporting
unit’s expected cash flows and incorporates management’s detailed knowledge of
products, pricing, competitive environment, global economic conditions, industry
conditions, interest rates, and management actions, whereas market information
may not be available, or may be less precise due to a lack of comparability to
the Company’s particular reporting unit. The second step requires the Company to
determine the implied fair value of goodwill and measure the impairment loss as
the difference between the book value of the goodwill and the implied fair value
of the goodwill. The implied fair value of goodwill must be determined in the
same manner as if the Company had acquired those reporting units.




Legislation
passed by the Federal Council of Germany in November 2008 and which became
effective on April 1, 2009, resulted in sweeping changes to the way doctors
and healthcare providers interact and are reimbursed from insurance companies.
These changes require the Company’s German subsidiary to renegotiate contracts
with insurance companies and ENT doctors on a new basis. In the first three
months of 2009, the Company believed its German subsidiary was making progress
in negotiating new contracts. However, on April 1, 2009, the Company was
notified by one large insurance company representing approximately 25% of its
German revenue that, despite several months of favorable negotiations, due to
“political headwinds”, they were refusing to enter into a contract; therefore,
the Company’s German subsidiary filed a lawsuit in the Social Court in Hamburg,
Germany against this insurance company, requesting that the court compel the
insurance company to enter into a contract with it. On April 28, 2009, the
Court rejected these claims. The Company’s German subsidiary subsequently filed
an appeal of this decision, which was rejected without review. Without
renegotiated insurance contracts, and the ability to pay customary fitting fees
to the ENT doctors, the Company expected revenue to decline substantially and
cash flow of the operation would not be sufficient to support its intangibles
balances.




The
Company determined that an interim impairment test was necessary at the end of
the first quarter of 2009 in this reporting unit. In the step one calculation,
the Company assumed a full year revenue of approximately 45% of 2008 levels
(which resulted from a full first quarter 2009 and approximately 27% of revenue
thereafter) and operating expenses of approximately 90% of 2008 levels as the
Company continued to attempt to renegotiate additional contracts and service
existing contracts. However, renegotiation was expected to be difficult given
the political pressures posed by local acousticians, the Company’s largest
competitors, and the adverse result in the social court case. Accordingly, the
Company could not reasonably expect revenue in excess of those contracts which
had already been renegotiated for one year terms. In addition, there continued
to be high risk that some or all of the insurance companies who had renegotiated
their contracts would not renew their contracts with the Company upon expiration
in April 2010 given the political climate and the social court decision.
Accordingly, the Company estimated that it would maintain the 27% of revenue for
one year and would be unable to successfully renegotiate with additional
insurers. The Company used a discount rate of 14.5%. A sensitivity analysis was
not performed given the significant disparity between the estimated fair value
and carrying value. Reasonable changes to the assumptions used, based on
then-existing facts and circumstances, would not have changed the outcome. After
completing step one of the prescribed test, the Company determined that the
estimated fair value of the reporting unit was less than its book value on
March 31, 2009. The Company performed the step two test and concluded that
the reporting unit’s goodwill and trade name were impaired. As a result, an
impairment loss of $14,205 for goodwill and $453 for definite lived intangibles
was recorded in the first quarter of 2009 in the Company’s Europe
segment.


10





Goodwill
and indefinite-lived intangible assets (arrangement with the Australian
government to supply hearing aids) in 2010 and 2009 were as
follows:





North
                            America
                          
                          
                          Europe
                          
                          
                          Rest-of-
                            World
                          
                          
                          TotalBalance as of December 31, 2009Goodwill
                          
                          $
                          16,033
                          
                          
                          $
                          22,385
                          
                          
                          $
                          9,368
                          
                          
                          $
                          47,786Accumulated
      impairment charges
                          
                          
                          (14,632
                          )
                          
                          
                          (16,014
                          )
                          
                          
                          -
                          
                          
                          
                          (30,646
                          )1,401
                          
                          
                          
                          6,371
                          
                          
                          
                          9,368
                          
                          
                          
                          17,140Goodwill
      acquired during the period
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          18
                          
                          
                          
                          18Effect
      of exchange rate changes
                          
                          
                          -
                          
                          
                          
                          (392
                          )
                          
                          
                          275
                          
                          
                          
                          (117
                          )Balance
      as of March 31, 2010Goodwill
                          
                          
                          16,033
                          
                          
                          
                          21,993
                          
                          
                          
                          9,661
                          
                          
                          
                          47,687Accumulated
      impairment charges
                          
                          
                          (14,632
                          )
                          
                          
                          (16,014
                          )
                          
                          
                          -
                          
                          
                          
                          (30,646
                          )$
                          1,401
                          
                          
                          $
                          5,979
                          
                          
                          $
                          9,661
                          
                          
                          $
                          17,041




Definite-lived intangible
assets consisted of the following:





March 31, 2010
                                              
                                              
                                              December 31,2009Useful
                                              
                                              Gross Carrying
                                              
                                              
                                              Accumulated
                                              
                                              
                                              Gross Carrying
                                              
                                              
                                              AccumulatedLives
                                              
                                              Value
                                              
                                              
                                              Amortization
                                              
                                              
                                              Value
                                              
                                              
                                              AmortizationPurchased
      technology and licenses
                                              3-13 years
                                              
                                              $
                                              2,031
                                              
                                              
                                              $
                                              1,396
                                              
                                              
                                              $
                                              1,976
                                              
                                              
                                              $
                                              1,357Brand
      and trade names
                                              1-3
      years
                                              
                                              
                                              129
                                              
                                              
                                              
                                              129
                                              
                                              
                                              
                                              129
                                              
                                              
                                              
                                              129Customer
      databases
                                              2-10
      years
                                              
                                              
                                              7,429
                                              
                                              
                                              
                                              6,007
                                              
                                              
                                              
                                              7,433
                                              
                                              
                                              
                                              5,940Non-compete
      agreements
                                              1-5
      years
                                              
                                              
                                              2,153
                                              
                                              
                                              
                                              1,331
                                              
                                              
                                              
                                              2,189
                                              
                                              
                                              
                                              1,285Total
                                              
                                              
                                              $
                                              11,742
                                              
                                              
                                              $
                                              8,863
                                              
                                              
                                              $
                                              11,727
                                              
                                              
                                              $
                                              8,711




3.
LONG-TERM DEBT




As of
March 31, 2010, the current portion of long-term debt was $6,658 and the
long-term portion was $159. Future payments on long-term debt consisted of the
following as of March 31, 2010:





Future
      PaymentsEffective
                                    Interest Rate
                                  
                                  Total
                                  
                                  
                                  Rest of
                                    2010
                                  
                                  
                                  2011
                                  
                                  
                                  2012German
      loan
                                  
                                  9.59%
                                  
                                  $
                                  1,345
                                  
                                  
                                  $
                                  1,009
                                  
                                  
                                  $
                                  336
                                  
                                  
                                  $
                                  -Acquisition
      loans & other
                                  
                                  0.0-12.25%
                                  
                                  
                                  361
                                  
                                  
                                  
                                  159
                                  
                                  
                                  
                                  120
                                  
                                  
                                  
                                  82Line
      of credit
                                  
                                  4.40%
                                  
                                  
                                  5,145
                                  
                                  
                                  
                                  5,145
                                  
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -Total
                                  
                                  
                                  
                                  
                                  6,851
                                  
                                  
                                  
                                  6,313
                                  
                                  
                                  
                                  456
                                  
                                  
                                  
                                  82Less
      imputed interest
                                  
                                  
                                  
                                  
                                  (34
                                  )
                                  
                                  
                                  (18
                                  )
                                  
                                  
                                  (14
                                  )
                                  
                                  
                                  (2
                                  )Total
      carrying amount
                                  
                                  
                                  
                                  $
                                  6,817
                                  
                                  
                                  $
                                  6,295
                                  
                                  
                                  $
                                  442
                                  
                                  
                                  $
                                  80




The
German bank loan bears interest at the EURIBOR rate plus 4.0%. As of March 31,
2010, the balance of the loan was €1,000 ($1,345). The loan payments are €250
($336 as of March 31, 2010) per quarter. In September 2008, the Company
entered into an interest rate swap agreement with an initial notional amount of
€2,500 to be reduced €250 per quarter through January 2011. Under this
agreement the Company receives a floating rate based on the EURIBOR interest
rate, and pays a fixed rate of 9.59% on the notional amount effectively fixing
the interest rate on the Company’s German loan. Therefore, the effective
interest rate on this loan was 9.59% for the three months ended March 31, 2010
and 2009.


11




Acquisition
loans relate to the purchase of retail audiology practices acquired under the
Company’s retail distribution initiative. Generally, these notes are secured by
the acquired assets, subordinated to the revolving credit facility, and are due
in annual installments from the acquisition date.




The
Company entered into a Loan and Security Agreement with Silicon Valley Bank
(“SVB”), providing for a revolving credit facility, under which borrowings of up
to $6,000 were available. The credit facility is secured by substantially all
tangible U.S. assets. There is an annual fee of 0.375% on the average unused
portion of the credit facility. Borrowings under the credit facility are subject
to interest at the domestic prime rate. If the adjusted quick ratio is greater
than or equal to 1.25 to 1.0, then the interest rate is the Prime Rate plus 0.25
percentage point; if the adjusted quick ratio is less than 1.25 to 1.0, then the
interest rate is the Prime Rate plus 0.50 percentage point. As of March 31,
2010, the interest rate on the Company’s line of credit was 4.4% and the
Company’s outstanding borrowings of $5,145 represented the maximum allowable
borrowing under the terms of the agreement.




On
March 10, 2010, the Company finalized the Second Amendment to the Amended
and Restated Loan and Security Agreement with SVB to renew and extend the
revolving credit facility to April 11, 2011. The amendment modified the
previous agreement to provide additional borrowing capacity of unrestricted cash
held at SVB up to $2,000, no longer reduced borrowing capacity related to
foreign currency hedging instruments, and modified the EBITDA requirement, as
follows:




Period
                                  
                                  Calculation Method
                                  
                                  Minimum RequirementJanuary 1
      - March 31, 2010
                                  
                                  Cumulative
                                  
                                  $2,000 lossApril 1
      - May 31, 2010
                                  
                                  Trailing three months
                                  
                                  $1,000
      lossJune 1
      - September 30, 2010
                                  
                                  Trailing
      three months
                                  
                                  $0.001 incomeThereafter
                                  
                                  Trailing
      three months
                                  
                                  $500
      income




The fair
value of the Company’s debt obligations approximates the carrying value as of
March 31, 2010. The Company is in compliance with its debt covenants as of March
31, 2010. Both the revolving credit facility and the German bank debt have a
customary material adverse change clause that allows the banks to call the
loans, if invoked. Neither bank has invoked this clause. In accordance with ASC
470-10, the Company has classified the outstanding balance on the revolving
credit facility as a short term liability as of March 31, 2010 and December 31,
2009, respectively, due to the inability of the Company to determine the
likelihood that any future events or circumstances affecting the Company may
constitute a material adverse event under the terms of the revolving credit
facility agreement causing SVB to exercise its right to accelerate payment of
amounts due under the revolving credit facility agreement. At March 31, 2010,
the Company’s net borrowings on this line of credit were $5,145 and net
borrowings on this line of credit at December 31, 2009 were $3,116.




4.
LEGAL PROCEEDINGS




In
February 2006, the former owners of Sanomed, which the Company acquired in 2003,
filed a lawsuit in German civil court claiming that certain deductions made by
the Company against certain accounts receivable amounts and other payments
remitted to the former owners were improper. The former owners sought damages in
the amount of approximately €2,600 ($3,400). The Company filed its statement of
defense and presented its position during oral arguments. The court asked the
parties to attempt to settle the matter and on July 20, 2009, the Company
and the former owners agreed to settle the claim. Under the terms of the
settlement, the Company agreed to pay the former owners of Sanomed an aggregate
sum of €1,050 ($1,471), approximately the amount reserved in the Company’s
balance sheet at December 31, 2008 for this matter. The Company remitted
the settlement payment in August 2009.




As part
of the Sanomed purchase agreement, the former owners were entitled to contingent
consideration based on the achievement of certain revenue milestones. In certain
circumstances, the former owners were entitled to contingent consideration
irrespective of the achievement of the revenue milestones. In addition to the
above noted lawsuit, two of the former owners filed suits against the Company,
one of which was settled in 2007, and the other former owner’s contingent
consideration claim against the Company for approximately €1,100 ($1,480) plus
interest was dismissed in July 2008, with the German court rendering its
decision in favor of the Company. The former owner has appealed. The Company
continues to strongly deny the allegations contained in the former owner’s
appeal and intends to defend itself vigorously; however, litigation is
inherently uncertain and an unfavorable result could have a material adverse
effect on the Company. The Company establishes reserves when a particular
contingency is probable and estimable.





From time
to time the Company is subject to legal proceedings, claims and litigation
arising in the ordinary course of its business. Most of these legal actions are
brought against the Company by others and, when the Company feels it is
necessary, it may bring legal actions against others. Actions can stem from
disputes regarding the ownership of intellectual property, customer claims
regarding the function or performance of the Company’s products, government
regulation or employment issues, among other sources. Litigation is inherently
uncertain, and therefore the Company cannot predict the eventual outcome of any
such lawsuits. However, the Company does not expect that the ultimate resolution
of any known legal action, other than as identified above, will have a material
adverse effect on its results of operations and financial
position.


12





5.
RESTRUCTURING





During
the three months ended March 31, 2009, the Company did not have any
restructuring charges. During 2009, the Company took actions to improve
profitability by 1) reducing the total number of employees in North America; 2)
closing three U.S. retail locations resulting in a restructuring charge of $98
and goodwill and definite-lived intangible write-off of $135; and 3) reducing
headcount and selling two retail shops in Europe. The total restructuring charge
from these actions was $769, which included $158 in sale proceeds from the two
European shops. During the three months ended March 31, 2010, the Company
reversed accruals of $20 primarily relating to favorable lease settlements and
made payments as listed in the following table in relation to its 2008 and 2009
restructuring charges:





Employee
                    Related
                  
                  
                  Excess
                    Facilities
                  
                  
                  Impairment
                    andOther
                  
                  
                  TotalBalance,
      December 31, 2009
                  
                  $
                  289
                  
                  
                  $
                  22
                  
                  
                  $
                  45
                  
                  
                  $
                  356Restructuring
      charge adjustments
                  
                  
                  -
                  
                  
                  
                  (20
                  )
                  
                  
                  -
                  
                  
                  
                  (20
                  )Payments
      and foreign exchange
                  
                  
                  (193
                  )
                  
                  
                  (2
                  )
                  
                  
                  (6
                  )
                  
                  
                  (201
                  )Balance,
      March 31, 2010
                  
                  $
                  96
                  
                  
                  $
                  -
                  
                  
                  $
                  39
                  
                  
                  $
                  135




6.
DISCONTINUED OPERATIONS




In 2008,
a decision was made to divest certain European operations. The Company sold one
European operating unit and closed a second operation. These operations have
been classified as discontinued operations in the Condensed Consolidated
Statements of Operations for the three months ended March 31, 2010 and
2009.




The
following amounts relate to discontinued operations and have been segregated
from continuing operations:




Forthethreemonths
                    endedMarch31,2010
                  
                  
                  2009Net
      sales
                  
                  $
                  -
                  
                  
                  $
                  (74
                  )Loss
      from discontinued operations, net of zero taxes
                  
                  $
                  (7
                  )
                  
                  $
                  (45
                  )


13




7.
SEGMENT INFORMATION




As of
March 31, 2010, the Company has three operating segments for which separate
financial information is available and evaluated regularly by management in
deciding how to allocate resources and assess performance. The Company evaluates
performance principally based on net sales and operating profit.




The
Company’s three operating segments include North America, Europe and
Rest-of-World. Inter-segment sales are eliminated in consolidation.
Manufacturing profit and distributors’ sales are recorded in the geographic
location where the sale occurred. This information is used by the chief
operating decision maker to assess the segments’ performance and in allocating
the Company’s resources. The Company does not allocate research and development
expenses to its operating segments.





North America
                
                
                Europe
                
                
                Rest-of-World
                
                
                Unallocated
                
                
                TotalThree
      months ended March 31, 2010Net
      sales to external customers
                
                $
                6,951
                
                
                $
                6,116
                
                
                $
                7,710
                
                
                $
                -
                
                
                $
                20,777Operating
      profit (loss)
                
                
                (3,377
                )
                
                
                1,179
                
                
                
                791
                
                
                
                (1,065
                )
                
                
                (2,472
                )Income
      (loss) from continuing operations
                
                
                (3,359
                )
                
                
                1,185
                
                
                
                913
                
                
                
                (1,065
                )
                
                
                (2,326
                )Three
      months ended March 31, 2009Net
      sales to external customers
                
                
                8,216
                
                
                
                11,077
                
                
                
                5,139
                
                
                
                -
                
                
                
                24,432Operating
      profit (loss)
                
                
                (3,234
                )
                
                
                (11,819
                )
                
                
                237
                
                
                
                (1,979
                )
                
                
                (16,795
                )Income
      (loss) from continuing operations
                
                
                (3,286
                )
                
                
                (11,898
                )
                
                
                240
                
                
                
                (1,979
                )
                
                
                (16,923
                )As
      of March 31, 2010Identifiable
      segment assets
                
                
                32,450
                
                
                
                13,588
                
                
                
                21,040
                
                
                
                -
                
                
                
                67,078Goodwill
      and indefinite-lived intangible assets
                
                
                1,401
                
                
                
                5,979
                
                
                
                9,661
                
                
                
                -
                
                
                
                17,041Long-lived
      assets
                
                
                5,524
                
                
                
                372
                
                
                
                2,896
                
                
                
                -
                
                
                
                8,792As
      of December 31, 2009Identifiable
      segment assets
                
                
                30,237
                
                
                
                16,431
                
                
                
                20,457
                
                
                
                -
                
                
                
                67,125Goodwill
      and indefinite-lived intangible assets
                
                
                1,401
                
                
                
                6,371
                
                
                
                9,368
                
                
                
                -
                
                
                
                17,140Long-lived
      assets
                
                
                5,477
                
                
                
                430
                
                
                
                2,848
                
                
                
                -
                
                
                
                8,755




The
following table represents revenues and long-lived assets that are considered
material to the Company’s operations by segment:





Revenues
                                          
                                          
                                          Long-livedassetsMarch31,2010
                                          
                                          
                                          March31,2009
                                          
                                          
                                          March31,2010
                                          
                                          
                                          December31,2009NorthAmericaU.S.
      wholesale
                                          
                                          
                                          53
                                          %
                                          
                                          
                                          55
                                          %
                                          
                                          
                                          93
                                          %
                                          
                                          
                                          92
                                          %U.S.
      retail
                                          
                                          
                                          37
                                          %
                                          
                                          
                                          35
                                          %
                                          
                                          
                                          6
                                          %
                                          
                                          
                                          7
                                          %EuropeGermany
                                          
                                          
                                          67
                                          %
                                          
                                          
                                          78
                                          %
                                          
                                          
                                          92
                                          %
                                          
                                          
                                          93
                                          %Rest-of-WorldAustralia
                                          
                                          
                                          100
                                          %
                                          
                                          
                                          100
                                          %
                                          
                                          
                                          100
                                          %
                                          
                                          
                                          100
                                          %




Long-lived
assets consist of property and equipment. The majority of the Company’s assets
as of March 31, 2010 and December 31, 2009 were attributable to its U.S.
operations.


14




ITEM 2.            
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS (Amounts in thousands, except per share data)




This
report contains “forward-looking statements” within the meaning of
Section 27A of the Securities Act of 1933, as amended, and Rule 175
promulgated thereunder, and Section 21E of the Securities Exchange Act of
1934, as amended, and Rule 3b-6 promulgated thereunder, that involve inherent
risks and uncertainties. Any statements about our plans, objectives,
expectations, strategies, beliefs, or future performance or events constitute
forward-looking statements. Such statements are identified as those that include
words or phrases such as “believes,” “expects,” “anticipates,” “plans,” “trend,”
“objective,” “continue” or similar expressions or future or conditional verbs
such as “will,” “would,” “should,” “could,” “might,” “may” or similar
expressions. Forward-looking statements involve known and unknown risks,
uncertainties, assumptions, estimates and other important factors that could
cause actual results to differ materially from any results, performance or
events expressed or implied by such forward-looking statements. All
forward-looking statements are qualified in their entirety by reference to the
factors discussed more fully in Item 1A of our Form 10-K for the year ended
December 31, 2009: (i) deterioration of economic conditions; (ii) our
continued losses; (iii) aggressive competitive factors;
(iv) fluctuations in our financial results; (v) our common stock could
be subject to delisting; (vi) negative impact of our recent acquisition
activities; (vii) ineffective internal financial control systems;
(viii) dependence on significant customers; (ix) dependence on
critical suppliers and contractors; (x) high levels of product returns and
repairs; (xi) inability to introduce new and innovative products;
(xii) undiscovered product errors or defects; (xiii) potential
infringement on the intellectual property rights of others;
(xiv) uncertainty of intellectual property protection; (xv) dependence
on international operations; (xvi) potential product liability;
(xvii) failure to comply with FDA regulations; (xviii) our stock price
could suffer due to sales of stock by our directors and officers; (xix) our
charter documents and shareholder agreements may prevent certain acquisitions;
and (xx) debt covenant default.




Because
the foregoing factors could cause actual results or outcomes to differ
materially from those expressed or implied in any forward-looking statements,
undue reliance should not be placed on any forward-looking statements. Further,
any forward-looking statement speaks only as of the date on which it is made,
and we undertake no obligation to update any forward-looking statement to
reflect events or circumstances after the date on which the statement is made or
to reflect the occurrence of future events or developments.




OVERVIEW




Otix is a
premier provider of technologically advanced hearing care solutions focused on
the therapeutic aspects of hearing care. We design, develop, manufacture, market
and distribute high-performance digital hearing aids intended to provide the
highest levels of satisfaction for hearing impaired consumers. We have developed
patented digital-signal-processing (“DSP”) technologies based on what we believe
is an advanced understanding of human hearing. In countries where we have direct
(owned) operations, we sell our products to hearing care professionals or
directly to hearing impaired consumers. In other parts of the world, where we do
not have direct operations, we sell primarily to distributors.




We were
acquisitive after raising capital in an initial public offering in 2000 and a
Private Investment in a Public Equity (“PIPE”) offering in 2006. Product
evolution continues, but the differentiation between product offerings by
hearing aid companies and new generations has narrowed, and thus distribution
and access to distribution continues to grow in importance. Accordingly, we
acquired a number of our then distributors between the years 2000 to 2003.
Thereafter, we acquired an operation in Germany with a unique distribution model
using the Ear-nose-throat (“ENT”) physician. Then, from 2006 to 2008, we
acquired a number of retail practices. This was all to strengthen our
distribution network.




Germany Legislation.
Legislation passed by the Federal Council of Germany in November 2008 and which
became effective on April 1, 2009, resulted in sweeping changes to the way
doctors and healthcare providers interact and are reimbursed by insurance
companies. A major change in regulation directly affecting our German subsidiary
was the prohibition of direct fitting fee payments from hearing aid retailers to
doctors. Under our German government approved business model, the new
legislation requires that the fitting fee payments to the doctors come from the
insurance companies rather than us. The direct payment to doctors for fitting
services under our business model was one of the keys to success for our sales
channel in Germany. The law changed the market by giving more power to the
insurers by allowing discretion as to which business models to which they supply
hearing aids and related services. Insurers are the sole gatekeepers for access
to the reimbursement schemes for the end consumer. These changes required our
German subsidiary to a) develop a new business process with the insurance
companies to create a service company for invoicing, receiving and paying out
the doctor’s honorarium; b) renegotiate contracts with insurance companies; and
c) negotiate contracts between and with the insurance company and the ENT
doctors. In the first three months of 2009, we believed our German subsidiary
was making progress in negotiating new contracts. However, on April 1,
2009, we were notified by one large insurance company representing approximately
25% of our 2008 German revenue that, despite several months of favorable
negotiations, due to “political headwinds,” they were refusing to enter into a
contract; therefore, our German subsidiary filed a lawsuit in the Social Court
in Hamburg, Germany against this insurance company, requesting that the court
compel the insurance company to enter into a contract with our German
subsidiary. On April 28, 2009, the Court rejected these claims. We
subsequently filed an appeal of this decision, which was rejected without
review. Without renegotiated insurance contracts, and the ability to pay
customary fitting fees to the ENT doctors, we expected revenue to decline
substantially and cash flow of the operation would not be sufficient to support
our intangibles balances. As a result, we recognized a $14,658 non-cash
write-off of our goodwill and trade name associated with our German operation in
the first quarter of 2009.


15




In June
2009, the German government passed additional amendments to the law that became
effective July 23, 2009. The key implication of these amendments to our
business model was to impose additional costs on the doctors and insurance
companies that conduct business with our German operation and disrupt the normal
flow of fitting hearing aids on the first visit to the doctor’s
office.




We are
currently renegotiating contracts in light of the new legislative requirements
and are working to contract with other insurance companies as well. The
lack of signed insurance contracts and the imposition of new and costly
requirements on the ENT doctors and the insurance companies as well as the
uncertainty of regulatory requirements will continue to impact our
German business. Final regulatory requirements are expected to be completed
during the second quarter 2010, the impact of which is unknown at this
time.




Germany
represented 67% and 78% of Europe segment revenues and 71% and 89% (excluding
first quarter 2009 impairment charges) of Europe segment operating profit for
the quarter ended March 31, 2010 and 2009, respectively.




Market




The
market for hearing aids is very large and has substantial unmet needs. Industry
researchers estimate that approximately 10% of the population suffers from
hearing loss. There is no single, audited source of sales data for the worldwide
hearing aid market, but U.S. data is maintained by the Hearing Industry
Association and is generally adopted and used by the industry as a proxy for
worldwide data. As depicted in the following table, less than 25% of the U.S.
total population in 2008 that could benefit from a hearing aid actually owned a
hearing aid:




2004
                              
                              
                              2008
                              
                              
                              ChangeHearing
      Loss PopulationU.S.
      households (millions)
                              
                              
                              111.1
                              
                              
                              
                              116.1
                              
                              
                              
                              4.5
                              %Hearing
      difficulty per 1,000 households
                              
                              
                              283
                              
                              
                              
                              295
                              
                              
                              
                              4.2
                              %Number
      of hearing impaired (millions)
                              
                              
                              31.5
                              
                              
                              
                              34.3
                              
                              
                              
                              8.9
                              %2004
                              
                              
                              2008
                              
                              
                              ChangeHearing
      Aid PopulationHearing
      aid adoption rate
                              
                              
                              23.5
                              %
                              
                              
                              24.6
                              %
                              
                              
                              4.7
                              %Hearing
      aid owners (millions)
                              
                              
                              7.4
                              
                              
                              
                              8.4
                              
                              
                              
                              13.5
                              %Hearing
      impaired, non-owners (millions)
                              
                              
                              24.1
                              
                              
                              
                              25.8
                              
                              
                              
                              7.1
                              %




The
hearing loss population has grown to 34.3 million. Over the last generation, the
hearing loss population grew at the rate of 1.6 times the U.S. population
growth, primarily due to the aging of America. Hearing aid adoption continues to
increase slowly (now 1 in 4 people with hearing loss) as do binaural fittings (8
out of 10). While 4 in 10 people with moderate-to-severe hearing loss use
amplification for their hearing loss, fewer than 1 in 10 people with mild
hearing loss use amplification. Hearing impaired people in this segment, which
comprise the majority of the hearing impaired population, often do not purchase
hearing aids for a variety of reasons, including their belief that their hearing
loss is not significant enough to warrant hearing aids, their concern regarding
the stigma associated with wearing hearing aids and their perception that
existing hearing aids are uncomfortable, do not perform well, cannot solve
specific hearing problems and are too expensive.




Despite
this low level of market penetration, annual worldwide retail sales of hearing
aids are estimated to be over $6 billion and wholesale sales are estimated to be
over $2 billion. We anticipate that demographic trends, such as the aging of the
developed world’s population and increased purchasing power in developing
nations, will accelerate the growth of the hearing impaired population, which
should result in increasing hearing aid sales over time.




Offsetting
this trend are the following market conditions affecting us in a negative
way:




•
            Competition
      is intense and new product offerings by our competitors are coming to
      market more quickly than in the
past.




•
            The
      performance, features and quality of lower-priced products continue to
      improve.


16




•
            Many
      consumers feel that hearing aids are simply too expensive and they cannot
      justify the purchase on a cost-benefit
basis.




•
            Governments
      who reimburse for hearing aids are reducing the amount per device or are
      increasing the technology requirements for the same level of
      reimbursement.




•
            Our
      operations and performance depend on general economic conditions. The
      global economy is experiencing uncertainty which is causing slower
      economic activity, concerns about inflation, increased energy costs,
      decreased consumer confidence, and other adverse business conditions. Such
      fluctuations in the global economy could cause, among other results,
      deterioration and continued decline in consumer spending and increases in
      the cost of labor and materials.




•
            The
      available wholesale market continues to shrink as our competitors
      implement forward integration strategies and buying groups limit the
      number of manufacturers with whom they do business. Therefore, we plan to
      continue to develop and potentially acquire additional distribution
      capacities.




Product
Developments




We have
packaged our proprietary technologies into a broad line of digital hearing aids
that we believe offer superior sound quality, smaller size, enhanced
personalization and increased reliability at competitive prices. All of our
products incorporate our proprietary sound processing and are programmable to
address the hearing loss of the individual user. We currently sell our hearing
aid products both as completed hearing aids and as hearing aid kits, or
faceplates, to others who then market finished hearing aids generally under our
brand names.




Otix
launched Touch, our first receiver-in-canal (“RIC”) product family, in March
2009. RIC has become a very popular product type, representing approximately 35%
of hearing aids sold in the United States. In addition to its sophisticated
design, very small size and ease of use features, we believe Touch is the
smallest and has the best moisture resistance of any RIC product on the market.
Our Touch products incorporate many of the sound processing technologies present
in our Velocity series of hearing solutions. Touch provides natural sound
quality, superior noise-reduction, and excellent directionality, driven by our
unique DIRECTIONALfocus®technology. Touch is offered at three price points and available in a
choice of five base colors and 15 accent color clips. The three Touch
products are readily identified by the number of processing channels. Touch 6
has six channels and two programs, Touch 12 has 12 channels and three programs,
and Touch 24 has 24 channels, four programs and voice alerts.




In 2008,
Otix launched four new products specifically designed to provide competitive
features and additional price options for our customers. Velocity 24, our
premium product, combines a superior set of algorithms to provide the consumer
with hands-free operation in a variety of listening environments. Our new
advanced-level product, Velocity 12, offers many sophisticated features, such as
automatic and adaptive directionality, data logging, and auto telephone. With
Velocity 6, we have added a highly competitive mid-level product line. Velocity
4, our newest entry-level offering, makes our patented and proven
noise-reduction available at a price-point that is particularly attractive to
cost-sensitive consumers. All Velocity products are available in a full line of
custom models and feature a robust standard BTE that can accommodate a severe
hearing loss. Velocity 24, Velocity 12, and Velocity 6 also offer a miniBTE
model that provides both open-fit and standard fittings, a powerful fitting
range and extendable functionality such as Bluetooth and direct audio import
support.




Also in
2008, we added a new product offering in the microBTE class, ion 400. This style
of BTE is very small (about 20 mm long, 7 mm wide and 9 mm high) and is nearly
invisible behind the ear. Our Velocity and ion products are among the smallest
custom and behind-the-ear products available today. Because our microBTEs are
designed to be used with either a thin tube and open dome or a more conventional
tubing and earmold configuration, they offer increased fitting flexibility. When
paired with the thin tube and open dome, these products practically eliminate
the dissatisfying affect of occlusion.




The
market is using RIC and open-fit products to target the first-time hearing aid
wearer. The market for RIC and open-fit products has grown rapidly, as
illustrated by the Hearing Industries Association (“HIA”) data. The BTE
category, into which open-fit and RIC products fall, continues to grow as a
percentage of the hearing aid market, representing in excess of 55% of the units
sold in the United States, up from 51% in 2007 and 44% in 2006.




We now
have eight active product families – Touch, Velocity, ion, Balance, Applause,
Natura Pro, Natura 2SE and Quartet.




In May
2010, we launched the Endura super-power BTE which is the newest addition to our
product portfolio. Designed specifically for mild-to-profound hearing losses,
Endura provides not just high-level output, but also high-quality sound.
Featuring our patented sound processing, clinically proven noise reduction, and
advanced directional strategies. Endura provides the most natural listening
experience possible. With its emphasis on low- and mid-frequency amplification,
Endura provides more output across these frequencies than any other power or
super-power BTE. Endura also incorporates great ease-of-use features, such as
large user controls, connectivity to external Bluetooth devices, and integrated
direct audio input.


17


Distribution Developments




Hearing
aids are generally sold through the following distribution
channels:




•
            Independent
      retailers,




•
            Purchasing
      groups,




•
            Retail
      chains,




•
            Governments,




•
            Internet,
      and




•
            Manufacturer-owned
      retail.




The
growth today is in retail chains, governments, internet (small but growing) and
manufacturer-owned retail. Independent retailers are shrinking for a number of
reasons, but foremost due to consolidation through acquisition by large
retailers and manufacturers. We are competing in an industry that includes six
much larger competitors who have significantly more resources and have
established relationships and reputations. Our competitors continue to forward
integrate by buying independent retailers and offering financial arrangements
through loans and other lock-up agreements. Therefore, the market available for
us in the wholesale business is shrinking, making it difficult for us to compete
in the traditional distribution fashion. For this reason, we are interested in
both new and existing distribution methods. In certain cases, we sell direct to
the consumer utilizing the ENT doctor to perform the hearing aid fitting, while
in other cases, we sell directly to the consumer through various retail stores.
We believe a combination of wholesale and direct-to-consumer distribution will
continue to be critical for us in certain geographies.




In parts
of the world where we do not have direct operations, we sell principally to
distributors with payment terms ranging from cash-in-advance to 120 days.
Certain distributors are offered volume discounts that are earned upon meeting
unit volume targets. Distributor agreements do not convey price protection or
price concession rights.




Financial
Results




Our loss
from continuing operations of $2,326 for the three months ended March 31, 2010,
compared with a loss from continuing operations of $16,923 for the three months
ended March 31, 2009, was primarily impacted by the following
items:




•
            Non-cash
      goodwill and definite-lived intangibles impairment charge in the first
      quarter of 2009 of $14,658 as a result of an adverse legal decision and
      regulatory changes in Germany. Excluding this charge, the first quarter
      2009 loss from continuing operations was comparable to the first quarter
      of 2010.




•
            The
      legislative changes in Germany reduced our German sales and profitability.
      Operating profit in our Europe segment was reduced by $1,660 from $2,839
      in the first quarter of 2009 to $1,179 in the first quarter of 2010 after
      excluding the impairment charge discussed
above.




•
            A
      decline in North America unit sales of 17% and 10% in wholesale and
      retail, respectively.




•
            Offsetting
      the aforementioned is a reduction in corporate and research and
      development expenses of $1,389 for the three months ended March 31, 2010
      compared to the same period in
2009.




Our
future sales and financial results for the next 12 months are expected to be
driven by the following items:




•
            Continued
      penetration of the Touch product family. We have launched the product in
      all our major markets, including Germany early in the fourth quarter 2009.
      Touch and ion (open fit products) are product types that are experiencing
      growing demand in the marketplace.




•
            Launching
      Endura, our super-power BTE product, in May 2010 for those individuals
      with profound hearing loss.




•
            Focusing
      on improving the results of retail audiology practices we acquired between
      2006 and 2008.




•
            Continued
      focus on cost savings. We will significantly reduce a direct to consumer
      marketing initiative in the second quarter of 2010 that was begun in the
      third quarter of 2009.  We have spent approximately $1,200 over
      the past three quarters, including $457 in the first quarter of 2010 on
      this initiative.




•
            Sales
      growth with the U.S. Veteran’s Administration (“the VA”). The contract
      began in November of 2009. According to data from the Hearing Industry
      Association, the VA represents approximately 18% of the market for hearing
      aids and experienced unit growth of more than 20% annually this past year.
      We were successful in receiving an award in each of the categories in
      which we bid, allowing us to sell our custom, behind-the-ear and
      receiver-in-canal products through the VA. The contract award from the VA
      is a one-year contract with four one-year extensions, at the VA’s option.
      We anticipate participating on the contract for the entire five years.
      According to contract documents, the VA anticipates purchasing a total of
      approximately 430,000 hearing aids across the nine contract awardees in
      the first year, with steady growth in volume over the following four
      years. We are experiencing increasing sales to the VA and we expect to
      incur training and startup costs relating to the VA contract in the second
      quarter of approximately $200.


18




Offsetting
these developments will be the possible
continued decline of sales to insurance companies in our German operation as a
result of future potential regulatory changes.





The
following table sets forth selected statement of operations information for the
periods indicated expressed as a percentage of net sales.




Three months ended
              March31,2010
            
            
            2009Net
      sales
            
            
            100.0
            %
            
            
            100.0
            %Cost
      of sales
            
            
            35.9
            %
            
            
            42.0
            %Gross
      profit
            
            
            64.1
            %
            
            
            58.0
            %Selling,
      general and administrative expense
            
            
            71.0
            %
            
            
            58.6
            %Research
      and development expense
            
            
            5.1
            %
            
            
            8.1
            %Goodwill
      and definite-lived intangibles impairment charges
            
            
            0.0
            %
            
            
            60.0
            %Restructuring
      charges
            
            
            (0.1
            )%
            
            
            0.0
            %Operating
      loss
            
            
            (11.9
            )%
            
            
            (68.7
            )%Interest
      expense
            
            
            (0.2
            )%
            
            
            (0.6
            )%Other
      income, net
            
            
            0.1
            %
            
            
            0.4
            %Loss
      before income taxes
            
            
            (12.0
            )%
            
            
            (68.9
            )%Provision
      (benefit) for income taxes
            
            
            (0.8
            )%
            
            
            0.4
            %Loss
      from continuing operations
            
            
            (11.2
            )%
            
            
            (69.3
            )%Loss
      from discontinued operations, net of income taxes
            
            
            (0.0
            )%
            
            
            (0.2
            )%Net
      loss
            
            
            (11.2
            )%
            
            
            (69.5
            )%




Net Sales.Net sales consist
of product sales less a provision for sales returns, which is made at the time
of the related sale. Net sales by reportable operating segment were as
follows:





Three months ended March31,2010
                          
                          
                          2009
                          
                          
                          ChangeNorth
    America
                          
                          $
                          6,951
                          
                          
                          $
                          8,216
                          
                          
                          
                          (15.4
                          )%Europe
                          
                          
                          6,116
                          
                          
                          
                          11,077
                          
                          
                          
                          (44.8
                          )%Rest-of-World
                          
                          
                          7,710
                          
                          
                          
                          5,139
                          
                          
                          
                          50.0
                          %Total
      net sales
                          
                          $
                          20,777
                          
                          
                          $
                          24,432
                          
                          
                          
                          (15.0
                          )%




The
following table reflects the significant components of sales activity for the
three months ended March 31, 2009 to the three months ended March 31,
2010.





North
      America
                            
                            
                            Europe
                            
                            
                            Rest-of-World
                            
                            
                            Total$
                            
                            
                            %
                            
                            
                            $
                            
                            
                            %
                            
                            
                            $
                            
                            
                            %
                            
                            
                            $
                            
                            
                            %Sales
      for the three months ended March 31, 2009
                            
                            $
                            8,216
                            
                            
                            
                            
                            
                            
                            $
                            11,077
                            
                            
                            
                            
                            
                            
                            $
                            5,139
                            
                            
                            
                            
                            
                            
                            $
                            24,432Organic
      growth (reduction)
                            
                            
                            (1,367
                            )
                            
                            
                            (16.6
                            )%
                            
                            
                            (5,229
                            )
                            
                            
                            (47.2
                            )%
                            
                            
                            526
                            
                            
                            
                            10.2
                            %
                            
                            
                            (6,070
                            )
                            
                            
                            (24.8
                            )%Foreign
      currency
                            
                            
                            102
                            
                            
                            
                            1.2
                            %
                            
                            
                            268
                            
                            
                            
                            2.4
                            %
                            
                            
                            2,045
                            
                            
                            
                            39.8
                            %
                            
                            
                            2,415
                            
                            
                            
                            9.8
                            %Sales
      for the three months ended March 31, 2010
                            
                            $
                            6,951
                            
                            
                            
                            (15.4
                            )%
                            
                            $
                            6,116
                            
                            
                            
                            (44.8
                            )%
                            
                            $
                            7,710
                            
                            
                            
                            50.0
                            %
                            
                            $
                            20,777
                            
                            
                            
                            (15.0
                            )%




Net sales
from continuing operations for the three months ended March 31, 2010 of $20,777
decreased 15.0% from net sales from continuing operations of $24,432 for the
three months ended March 31, 2009. The decrease in sales is due to the
legislative changes in Germany and their impact on our ability to conduct
business, and declines in North America unit sales. These were partially
offset by a 50% increase in Rest-of-World sales.


19




North
America hearing aid sales of $6,951 for the three months ended March 31,
2010 were down 15.4% from the prior year three months ended March 31, 2009 sales
level of $8,216. The decrease in sales is due to declines in wholesale and
retail volume and pricing in the wholesale business. Wholesale and retail
volumes continue to decline over the same period in the prior year. We are
also finding increased price competition in the wholesale market as more
manufactures compete over less business in the North American independent
audiologist segment.




Europe
sales of $6,116 for the three months ended March 31, 2010 decreased 44.8% from
net sales of $11,077 for the three months ended March 31, 2009. Europe sales
were negatively impacted by the legislative changes in Germany. The legislative
changes in Germany impacted sales in two ways.  First, and most
importantly, is the impact of not having contracts with the insurers. Net units
in our German operation were down 63.8% in the first quarter of 2010 compared to
the same period in 2009.  Second, we previously billed the insurance
company the full price of a hearing aid, which included the doctor’s fee as part
of the reimbursement. Thus, we recorded the full reimbursement as revenue and
the payment to the ENT doctors as a cost of sale. We are now only billing for
the hearing aid, with the doctors billing separately for their fitting services
and no longer recording the doctor’s fees as revenue and cost of
sales.




Rest-of-World
sales of $7,710 for the three months ended March 31, 2010 increased 50.0% from
the three months ended March 31, 2009 sales of $5,139. First quarter organic
growth of 10.2% was due to having more fitters employed and additional marketing
spend, which translated into more sales. The Australian government was behind in
processing vouchers in the latter part of the fourth quarter 2009 and first
quarter 2010, and is now attempting to catch up.  In the past, this
has had an impact to reduce sales a couple of months after the slow down, and
then increase sales a couple of months after the government catches up. Foreign
currency translation increased sales by 39.8% due to the weakening of the U.S.
dollar against the Australian dollar.




We
generally have a 60 day return policy for wholesale hearing aid sales and 30
days for retail sales. Provisions for sales returns for continuing operations
were $1,275, or 5.8% and $2,307, or 8.6% of gross hearing aid sales from
continuing operations, for the three months ended March 31, 2010 and 2009,
respectively. The percentage decrease for the three months ended March 31, 2010
was driven by lower sales in wholesale, where return rates tend to be higher
than in our retail operations, and lower return rates in our wholesale
operation. Retail sales are recognized after fitting and “acceptance,” which
results in lower return rates, whereas in wholesale, revenue is recognized on
shipment and a reserve is established for expected returns. We believe that the
hearing aid industry, particularly in the U.S., experiences a high level of
product returns due to factors such as statutorily required liberal return
policies and product performance that is inconsistent with hearing impaired
consumers’ expectations.




Gross Profit.Cost of sales
primarily consists of manufacturing costs, royalty expenses, quality costs and
costs associated with product remakes and repairs (warranty). Gross profit and
gross margin by reportable operating segment were as follows:





ThreemonthsendedMarch31,2010
                          
                          
                          2009Continuing operationsNorth
    America
                          
                          $
                          3,347
                          
                          
                          48.2
                          %
                          
                          $
                          4,299
                          
                          
                          52.3
                          %Europe
                          
                          
                          4,115
                          
                          
                          67.3
                          %
                          
                          
                          6,527
                          
                          
                          58.9
                          %Rest-of-World
                          
                          
                          5,854
                          
                          
                          75.9
                          %
                          
                          
                          3,337
                          
                          
                          64.9
                          %Total
      gross profit
                          
                          $
                          13,316
                          
                          
                          64.1
                          %
                          
                          $
                          14,163
                          
                          
                          58.0
                          %




Gross
profit from continuing operations of $13,316 for the three months ended March
31, 2010 decreased 6.0% from the quarter ended March 31, 2009 gross profit
of $14,163, but gross margin increased to 64.1% in the first quarter of 2010
from 58.0% in the same period of 2009. The decrease in gross profit for the
first quarter is due to lower sales partially offset by higher gross margin. The
gross margin increased due to a slightly higher mix of retail sales, a weaker
U.S. dollar and a change in reimbursement in our German
business.  Partially offsetting this are higher warranty and material
costs related to our receiver-in-canal product family and sales to the Veterans
Administration which carry a much lower gross margin when compared to the
balance of our business.




North
America gross margin decreased to 48.2% for the three months ended March 31,
2010 from 52.3% for the three months ended March 31, 2009. The decrease in gross
margin is primarily a result of lower average selling prices, partially offset
by an increase in the percentage of retail sales which carry a higher gross
margin.




Europe
gross margin increased to 67.3% for the three months ended March 31, 2010 from
58.9% for the three months ended March 31, 2009. The higher gross margin is due
to the weakening of the U.S. dollar, which results in higher sales compared to
cost of goods sold which are denominated primarily in U.S. dollars, higher
average selling prices and a change in reimbursement for Germany. Previously we
recorded reimbursement for doctor fees as net sales and cost of
sales.  As a result of the recent German legislation, the doctors must
bill and collect for their services.  Thus, the fees are no longer
recorded as a sale and cost of sale.


20




Rest-of-World
gross margin increased to 75.9% for the three months ended March 31, 2010 from
64.9% for the three months ended March 31, 2009. The first quarter increase in
gross margin is a result of higher average selling price related to our Touch
family of products and the weakening of the U.S. dollar compared to the
Australian dollar. The Australian dollar has appreciated 26% over the past year
and our cost of sales is predominantly denominated in U.S. dollars.




Provisions
for warranty for continuing operations increased to $913 for the three months
ended March 31, 2010 from $735 for the three months ended March 31, 2009,
primarily due to sales of RIC products. The receiver assembly associated with
the RIC products may need to be replaced frequently and thus the warranty per
unit is higher than other products we sell. We adjust the warranty estimates as
we obtain more experience with this product line.




Selling, General and
Administrative. Selling, general and administrative expense primarily
consists of wages and benefits for sales and marketing personnel, sales
commissions, promotions and advertising, marketing support, distribution and
administrative, share-based compensation, and depreciation and amortization
expenses.




Selling,
general and administrative expense in dollars and as a percent of sales by
reportable operating segment was as follows:





ThreemonthsendedMarch31,2010
                          
                          
                          2009Continuing operationsNorth
    America
                          
                          $
                          6,765
                          
                          
                          97.3
                          %
                          
                          $
                          7,533
                          
                          
                          91.7
                          %Europe
                          
                          
                          2,915
                          
                          
                          47.7
                          %
                          
                          
                          3,688
                          
                          
                          33.3
                          %Rest-of-World
                          
                          
                          5,063
                          
                          
                          65.7
                          %
                          
                          
                          3,100
                          
                          
                          60.3
                          %Total
      selling, general and administrative
                          
                          $
                          14,743
                          
                          
                          71.0
                          %
                          
                          $
                          14,321
                          
                          
                          58.6
                          %




The
following table reflects the components of selling, general and administrative
expense for the three months ended March 31, 2009 to the three months ended
March 31, 2010.





NorthAmerica
                        
                        
                        Europe
                        
                        
                        Rest-of-World
                        
                        
                        Total$
                        
                        
                        %
                        
                        
                        $
                        
                        
                        %
                        
                        
                        $
                        
                        
                        %
                        
                        
                        $
                        
                        
                        %Selling,
      general and administrative expense for the three months ended March 31,
      2009
                        
                        $
                        7,533
                        
                        
                        
                        
                        
                        
                        $
                        3,688
                        
                        
                        
                        
                        
                        
                        $
                        3,100
                        
                        
                        
                        
                        
                        
                        $
                        14,321Organic
      growth (reduction)
                        
                        
                        (804
                        )
                        
                        
                        (10.7
                        )%
                        
                        
                        (922
                        )
                        
                        
                        (25.0
                        )%
                        
                        
                        621
                        
                        
                        
                        20.0
                        %
                        
                        
                        (1,105
                        )
                        
                        
                        (7.7
                        )%Foreign
      currency
                        
                        
                        36
                        
                        
                        
                        0.5
                        %
                        
                        
                        149
                        
                        
                        
                        4.0
                        %
                        
                        
                        1,342
                        
                        
                        
                        43.3
                        %
                        
                        
                        1,527
                        
                        
                        
                        10.6
                        %Selling,
      general and administrative expense for the three months ended March 31,
      2010
                        
                        $
                        6,765
                        
                        
                        
                        (10.2
                        )%
                        
                        $
                        2,915
                        
                        
                        
                        (21.0
                        )%
                        
                        $
                        5,063
                        
                        
                        
                        63.3
                        %
                        
                        $
                        14,743
                        
                        
                        
                        2.9
                        %





Selling,
general and administrative expense for the three months ended March 31, 2010 of
$14,743 increased by $422 or 2.9%, from the three months ended March 31, 2009
level of $14,321. Selling general and administrative expenses increased
primarily due to the weakening of the U.S. dollar, investments in additional
audiologists in our Rest-of-World segment and a direct to consumer initiative in
our North America segment.




North
America selling, general and administrative expense for the three months ended
March 31, 2010 of $6,765 decreased by $768, or 10.2%, from the three months
ended March 31, 2009 amount of $7,533. We cut our corporate overhead costs by
$476, or approximately 24.8%.  In addition, we have cut our costs in
our North America wholesale operation and increased our marketing spend in the
North America retail operation.  We expect to incur training and
startup costs relating to the VA contract in the second quarter of approximately
$200.




Europe
selling, general and administrative expenses for the three months ended March
31, 2010 of $2,915 decreased $773 or 21.0%. We decreased expenses in Europe as a
result the reduction in Germany net sales, partially offset by the weakening of
the U.S. dollar.




Rest-of-World
selling, general and administrative expense for the three months ended March 31,
2010 increased by $1,963 or 63.3%, primarily due to the weakening of the U.S.
dollar against the Australian dollar, which accounts for 43.3% of this
increase.  Additionally, personnel and marketing costs increased in
our Rest-of-World segment as we expect to continue to grow this business both in
sales and profitability.




21





Research and Development.
Research and development expense primarily consists of wages and benefits for
research and development, engineering, regulatory and clinical personnel and
also includes consulting, intellectual property, clinical studies and
engineering support costs. Research and development expense of $1,065, or 5.1%
of net sales, for the three months ended March 31, 2010 decreased $914, or
46.2%, over the research and development expense of $1,979, or 8.1% of net
sales, for the three months ended March 31, 2009. The decrease is a result of
eliminating approximately 20 positions in the second quarter of 2009. We are
outsourcing more of our research and development activities and therefore, we
expect that our royalty costs, classified in cost of sales, will increase in the
future to offset the reduced research and development expenditures. We
anticipate that outsourcing some of our research and development will
effectively expand our product offerings.





Restructuring and Impairment
Charges. In the first quarter of 2010, we had a reversal of $20 in
restructuring charges from adjustments of previous accrual estimates related to
favorable lease settlements. In the first quarter of 2009, as a result of the
German court decision previously described, we recognized a goodwill impairment
charge of $14,205 and a trade name impairment charge of $453, resulting in total
impairment charges of $14,658 related to our German operation.




Interest Expense and Other Income,
Net. Other income, net, primarily consists of foreign currency gains and
losses, interest income and other non-operating gains and losses. Interest
income was lower due to lower customer loan balances. Interest expense for the
three months ended March 31, 2010 was $51, which is $89 lower than the same
period in 2009 due to lower outstanding debt balances for acquisition related
debt, partially offset by increased borrowing on our line of
credit.




Provision (Benefit) for Income
Taxes. In some jurisdictions net operating loss carry-forwards reduce or
offset tax provisions. We had an income tax benefit from continuing operations
for the three months ended March 31, 2010 of $172 compared to an income tax
provision from continuing operations of $96 for the three months ended March 31,
2009.  The income tax benefit was the result of losses in foreign
locations where we pay taxes partially offset by pre-tax profits in foreign
geographies, alternative minimum tax in the U.S., and state taxes. The prior
year income tax provision was principally the result of pre-tax profits in
foreign geographies, alternative minimum tax in the U.S., amortization of
goodwill, and state taxes.




LIQUIDITY
AND CAPITAL RESOURCES




Our cash
flows from operating, investing and financing activities, as reflected in the
Condensed Consolidated Statement of Cash Flows for the three months ended March
31, 2010 and 2009 are summarized as follows:




For the three months
                    ended March 31,2010
                  
                  
                  2009Net
      cash provided by (used in) operating activities from continuing
      operations
                  
                  $
                  (976
                  )
                  
                  $
                  40Net
      cash provided by (used in) discontinued operations
                  
                  
                  (36
                  )
                  
                  
                  94Net
      cash provided by (used in) operating activities
                  
                  
                  (1,012
                  )
                  
                  
                  134Net
      cash used in investing activities
                  
                  
                  (90
                  )
                  
                  
                  (1,234
                  )Net
      cash provided by (used in) financing activities
                  
                  
                  1,440
                  
                  
                  
                  (2,196
                  )Effect
      of exchange rate changes on cash and cash equivalents from continuing
      operations
                  
                  
                  (153
                  )
                  
                  
                  (192
                  )Effect
      of exchange rate changes on cash and cash equivalents from discontinued
      operations
                  
                  
                  (1
                  )
                  
                  
                  (15
                  )Net
      increase (decrease) in cash and cash equivalents
                  
                  
                  184
                  
                  
                  
                  (3,503
                  )Cash
      and cash equivalents, beginning of the period
                  
                  
                  12,154
                  
                  
                  
                  13,129Cash
      and cash equivalents, end of the period
                  
                  $
                  12,338
                  
                  
                  $
                  9,626




Net cash
used in operating activities from continuing operations was $976 for the three
months ended March 31, 2010. Negative cash flow resulted from a net loss from
continuing operations of $2,333 which was positively affected by certain
non-cash expenses including depreciation and amortization of $843, share-based
compensation of $305, foreign currency loss of $351, loss on disposal of
long-lived assets of $20 and the amortization of discounts on long-term debt of
$1. Positive operating cash flow also resulted from a decrease in accounts
receivable of $394 primarily due to improved collection efforts and lower sales
during the first quarter of 2010, and an increase in accounts payable of $802.
These positive cash flow items were offset by a non-cash decrease in deferred
income taxes of $18, an increase in inventory of $1,084 and other assets of $36,
and a decrease in accrued restructuring of $221 and withholding taxes remitted
on share-based awards of $7.




Net cash
used in operating activities of discontinued operations was $36 for the three
months ended March 31, 2010.




Net cash
provided by operating activities from continuing operations was $40 for the
three months ended March 31, 2009. Negative cash flow resulted from a net
loss of $16,968 and was positively affected by certain non-cash expenses
including a goodwill and trade name impairment of $14,658 relating to our German
operation, depreciation and amortization of $1,047, stock-based compensation of
$468, and the amortization of discounts on long-term debt of $46, foreign
currency losses of $200, and deferred income taxes of $13. Positive operating
cash flow also resulted from a decrease in accounts receivables of $905
primarily due to collection efforts in the first quarter of 2009; an increase in
accounts payable, accrued expenses and deferred revenue of $1,195; and a
decrease in prepaid expenses and other assets of $126. These positive cash flow
items were partially offset by an increase in inventory of $1,477 for new
product launches; a decrease of accrued restructuring liabilities of $189; and
withholding taxes remitted on share-based awards of $29.


22




Net cash
provided by operating activities of discontinued operations was $94 for the
three months ended March 31, 2009.




Net cash
used in investing activities of $90 for the three months ended March 31, 2010
resulted from the purchase of property and equipment of $647, and purchase of a
technology license of $54 partially offset by net customer loan repayments of
$611.




Net cash
used in investing activities of $1,234 for the three months ended March 31,
2009 resulted from the purchase of property and equipment of $738 and net
customer advances of $496.




Net cash
provided by financing activities of $1,440 for the three months ended March 31,
2010 resulted from borrowings on the line of credit of $3,000 and proceeds from
taxes collected on the vesting of restricted shares of $7, partially offset by
repayments on the line of credit of $971 and principal payments on long-term
debt of $596.





Net cash
used in financing activities of $2,196 for the three months ended March 31,
2009 resulted from increases in restricted cash and cash equivalents of $64 and
principal loan payments of $2,152, partially offset by proceeds from the
exercise of stock options of $20.




In the
first quarter of 2010, we borrowed $3,000 on our revolving credit facility and
repaid $971, for a net increase of $2,029. Both the revolving credit facility
and the German bank debt have a customary material adverse change clause that
allows the banks to call the loans, if invoked. Neither bank has invoked such
clause.




Our cash
and cash equivalents, including restricted amounts, totaled $12,412 as of March
31, 2010. Our ability to make payments on and to refinance our indebtedness, and
to fund planned capital expenditures and ongoing operations, will depend on our
ability to generate cash in the future. This depends to a degree on general
economic, financial, competitive, legislative, regulatory and other factors that
are beyond our control. We plan to continue to manage receivables and
inventory and, together with available cash balances, we expect to be able
to fund our future debt service payments, ongoing operations and capital
expenditures. Based on our current level of operations, expected revenue
growth and anticipated cost management and operating improvements, we plan on
generating cash flow from operations in the latter part of 2010. The key to
this assumption will be our German operating performance. We expect that total
current debt service payments due over the next year of $6,658 will be paid
from available cash on hand, and anticipated cash flow from operations. We
believe that our cash and cash equivalents balance, along with cash flows from
operations, will be adequate to meet our operating, working capital and
investment requirements for the next year. As of March 31, 2010, our
outstanding borrowings on our line of credit of $5,145 represented the maximum
allowable borrowing under the terms of the agreement.




There can
be no assurance, however, that our business will generate sufficient cash flow
from operations, that currently anticipated cost savings and operating
improvements will be realized on schedule or that future borrowings will be
available to us in an amount sufficient to enable us to pay our indebtedness or
to fund our other liquidity needs. Furthermore, we cannot provide any assurances
that ongoing uncertainty in global capital markets and general economic
conditions will not have a material adverse impact on our future operations and
cash flows. We may need to refinance all or a portion of our indebtedness
on or before maturity and we cannot provide assurances that we will be able to
refinance any of our indebtedness on commercially reasonable terms, or at all.
Should we be unable to renegotiate our debt service payments, we may need to
sell assets of the company, which will also be subject to market conditions
existing at that time. Both the revolving credit facility and the German bank
debt have a customary material adverse change clause that allows the banks to
call the loans, if invoked. Neither bank has invoked this clause. We are in
compliance with our debt covenants as of March 31, 2010.




We
monitor our capital structure on an ongoing basis and from time to time we
consider financing and refinancing options to improve our capital structure and
to enhance our financial flexibility. Our ability to enter into new financing
arrangements is subject to restrictions in our outstanding debt instruments. At
any given time we may pursue a variety of financing opportunities, and our
decision to proceed with any financing will depend, among other things, on
prevailing market conditions, near term maturities and available
terms.




Contractual
Obligations




As of
March 31, 2010, we had unrecognized tax benefits of $286 of which $255 is
recorded as a liability and which could result in cash outlays in the event of
unfavorable taxing authority rulings.




There
have been no material changes to our contractual obligations outside the
ordinary course of business since December 31, 2009.


23




RECENT
ACCOUNTING PRONOUNCEMENTS




ASU
2009-13, “Revenue Recognition
(ASU Topic 605) – Multiple Deliverable Revenue Arrangements”, a consensus
of the FASB Emerging Issues Task Force which is effective for us in the first
quarter of fiscal year 2011, with early adoption permitted, modifies the fair
value requirements of ASC subtopic 605-25, “Revenue Recognition-Multiple
Element Arrangements”, by allowing the use of the “best estimate of
selling price” in addition to vendor-specific objective evidence (“VSOE”) and
verifiable objective evidence (“VOE”) (now referred to as “TPE” standing for
third-party evidence) for determining the selling price of a deliverable. A
vendor is now required to use its best estimate of the selling price when VSOE
or TPE of the selling price cannot be determined. In addition, the residual
method of allocating arrangement consideration is no longer permitted. In
October 2009, the FASB also issued ASU 2009-14, “Software (ASC Topic 985) –
Certain Revenue Arrangements That Include Software Elements”,a consensus
of the FASB Emerging Issues Task Force. This guidance modifies the scope of ASC
subtopic 965-605, “Software-Revenue Recognition”,to exclude from its requirements (a) non-software components of
tangible products and (b) software components of tangible products that are
sold, licensed, or leased with tangible products when the software components
and non-software components of the tangible product function together to deliver
the tangible product’s essential functionality. This update requires expanded
qualitative and quantitative disclosures once adopted. We are currently
evaluating the impact of adopting these pronouncements and do not expect the
standard to have a material impact on the condensed consolidated financial
statements.




ITEM
3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS




Interest Rate Risk.We
generally invest our cash in money market funds and corporate debt securities.
These are subject to minimal credit and market risk. As of March 31, 2010, we
had $2,461 held in commercial money market instruments that carry an effective
interest rate of 0.09%. The interest rates on our customer advances approximate
the market rates for comparable instruments and are fixed.




As of
March 31, 2010 we had $1,345 in short-term bank debt that bears interest at the
EURIBOR rate plus four percent.




A
hypothetical one percentage point change in interest rates would not have had a
material effect on our results of operations and financial position. Given
current interest rates, we believe the market risks associated with these
financial instruments are minimal.




Derivative Instruments and Hedging
Activities.We may employ derivative financial instruments to manage
risks, including the short term impact of foreign currency fluctuations on
certain intercompany balances, or variable interest rate exposures. We do not
enter into these contracts for trading or speculation purposes. Gains and losses
on the contracts are included in the results of operations and offset foreign
exchange gains or losses recognized on the revaluation of certain intercompany
balances, or interest expense due to movement in variable interest rates, as
applicable.




Our
foreign exchange forward contracts generally mature in three months or less from
the contract date. We held forward contract hedges on €3,800 ($5,135) and
Australian $500 ($457) at March 31, 2010. As of March 31, 2010, we
recognized an unrealized loss of $4 in connection with our foreign currency
forward contracts. The unrealized loss is recorded in Other income, net in the
Condensed Consolidated Statements of Operations, and in Prepaid expenses and
other in the Condensed Consolidated Balance Sheets. The contracts will expire in
the second quarter of 2010.




Effective
in the second quarter 2008, we entered into an interest rate swap agreement. The
contract effectively fixes the interest rate of our long term debt associated
with the German acquisition at 9.59%.




Foreign Currency Risk. We face
foreign currency risks primarily as a result of the revenues we derive from
sales made outside the U.S., expenses incurred outside the U.S., and from
intercompany account balances between our U.S. parent and our non-U.S.
subsidiaries. For the three months ended March 31, 2010, approximately
66.5% of our net sales and 54.1% of our operating expenses were denominated in
currencies other than the U.S. dollar. For the three months ended March 31,
2009, approximately 62.6% of our net sales and 40.5% or our operating expenses
were denominated in currencies other than the U.S. dollar.




Inventory
purchases were transacted in U.S. dollars. The local currency of each foreign
subsidiary is considered the functional currency, and revenue and expenses are
translated at average exchange rates for the reported periods. Therefore, our
foreign sales and expenses will be higher in a period in which there is a
weakening of the U.S. dollar and will be lower in a period in which there is a
strengthening of the U.S. dollar. The Australian dollar and Euro are our most
significant foreign currencies. Given the uncertainty of exchange rate
fluctuations and the varying performance of our foreign subsidiaries, we cannot
estimate the affect of these fluctuations on our future business, results of
operations and financial condition. Fluctuations in the exchange rates between
the U.S. dollar and other currencies could effectively increase or decrease the
selling prices of our products in international markets where the prices of our
products are denominated in U.S. dollars. For example, subsequent to March 31,
2010, the Euro significantly weakened against the U.S. dollar, which if
continued, will have a negative impact on our Europe segment operating results.
We regularly monitor our foreign currency risks and may take measures to reduce
the impact of foreign exchange fluctuations on our operating results. To date,
we have not used derivative financial instruments for hedging, trading or
speculating on foreign currency exchange, except to hedge intercompany
balances.


24




For the
three months ended March 31, 2010 and 2009, average currency exchange rates to
convert one U.S. dollar into each local currency for which we had sales of over
$5,000 by quarter were as follows:




2010
                            
                            2009Euro
                            
                            0.72
                            
                            0.77Australian
      dollar
                            
                            1.11
                            
                            1.51





ITEM
      4.
            CONTROLS
      AND PROCEDURES




Evaluation of Disclosure Controls
and Procedures.Under the supervision and with the participation of our
management, including our principal executive officer and principal financial
officer, we conducted an evaluation of the effectiveness of the design and
operation of our disclosure controls and procedures, as defined in Rules
13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 (the “Exchange
Act”), as of the end of the period covered by this report. Based on this
evaluation, our principal executive officer and principal financial officer
concluded that, as of the end of the period covered by this report, our
disclosure controls and procedures were effective.




Changes in Internal Controls Over
Financial Reporting.During the period covered by this report, there were
no changes in our internal control over financial reporting that have materially
affected, or are reasonably likely to materially affect, such internal controls
over financial reporting.




PART
II - OTHER INFORMATION




ITEM 1.
            LEGAL
      PROCEEDINGS




In
February 2006, the former owners of Sanomed, which we acquired in 2003, filed a
lawsuit in German civil court claiming that certain deductions made by us
against certain accounts receivable amounts and other payments remitted to the
former owners were improper. The former owners sought damages in the amount of
approximately €2,600 ($3,800). We filed our statement of defense and presented
our position during oral arguments. The court asked the parties to attempt to
settle the matter and, on July 20, 2009, we agreed to settle the claim with
the former owners. Under the terms of the settlement, we agreed to pay the
former owners of Sanomed an aggregate sum of €1,050 ($1,471), approximately the
amount reserved in our balance sheet at December 31, 2008 for this matter.
We remitted the settlement payment in August 2009.




As part
of the Sanomed purchase agreement, the former owners were entitled to contingent
consideration based on the achievement of certain revenue milestones. In certain
circumstances, the former owners were entitled to contingent consideration
irrespective of the achievement of the revenue milestones. In addition to the
above noted lawsuit, two of the former owners filed suit against us, one of
which was settled in 2007, and the other former owner’s contingent consideration
claim against us for approximately €1,100 ($1,480) plus interest was dismissed
on July 2008, with the German court rendering its decision in our favor. The
former owner has appealed. We continue to strongly deny the allegations
contained in the former owner’s appeal and intend to vigorously defend
ourselves; however, litigation is inherently uncertain and an unfavorable result
could have a material adverse effect. We establish liabilities when a particular
contingency is probable and estimable.




Also see
Item 1-A, below, regarding our recent litigation against a German insurance
company.




From time
to time, we are subject to legal proceedings, claims and litigation arising in
the ordinary course of its business. Most of these legal actions are brought
against us by others and, when we feel it is necessary, we may bring legal
actions. Actions can stem from disputes regarding the ownership of intellectual
property, customer claims regarding the function or performance of our products,
government regulation or employment issues, among other sources. Litigation is
inherently uncertain, and therefore, we cannot predict the eventual outcome of
any such lawsuits. However, we do not expect that the ultimate resolution of any
known legal action, other than as identified above, will have a material adverse
effect on our results of operations and financial position.




ITEM
      1-A.
            RISK
      FACTORS




In
addition to the risk factors set forth in this report, you should carefully
consider the factors discussed in Part I, Item 1-A, “Factors That May
Affect Future Performance” in our Annual Report on Form 10-K for the year ended
December 31, 2009 which could materially affect our business, results of
operations and financial position. The risks described in our Annual Report on
Form 10-K are not the only risks facing our Company. Additional risks and
uncertainties not currently known to us or that we currently deem to be
immaterial also may materially adversely affect our business, results of
operations and financial position.


25




Germany
Legislation




Legislation
passed by the Federal Council of Germany in November 2008 and which became
effective on April 1, 2009, resulted in sweeping changes to the way doctors
and healthcare providers interact and are reimbursed by insurance companies. A
major change in regulation directly affecting our German subsidiary was the
prohibition of direct fitting fee payments from hearing aid retailers to
doctors. Under our German government approved business model, the new
legislation requires that the fitting fee payments to the doctors come from the
insurance companies rather than us. The direct payment to doctors for fitting
services under our business model was one of the keys to success for our sales
channel in Germany. The law changed the market by giving more power to the
insurers by allowing discretion as to which business models they supply hearing
aids and related services. Insurers are the sole gatekeepers for access to the
reimbursement schemes for the end consumer. These changes required our German
subsidiary to a) develop a new business process with the insurance companies to
create a service company for invoicing, receiving and paying out the doctor’s
honorarium; b) renegotiate contracts with insurance companies; and c) negotiate
contracts between and with the insurance company and the ENT doctors. In the
first three months of 2009, we believed our German subsidiary was making
progress in negotiating new contracts. However, on April 1, 2009, we were
notified by one large insurance company representing approximately 25% of our
2008 German revenue that, despite several months of favorable negotiations, due
to “political headwinds,” they were refusing to enter into a contract;
therefore, our German subsidiary filed a lawsuit in the Social Court in Hamburg,
Germany against this insurance company, requesting that the court compel the
insurance company to enter into a contract with our German subsidiary. On
April 28, 2009, the Court rejected these claims. We subsequently filed an
appeal of this decision, which was rejected without review. Without renegotiated
insurance contracts, and the ability to pay customary fitting fees to the ENT
doctors, we expected revenue to decline substantially and cash flow of the
operation would not be sufficient to support our intangibles balances. As a
result, we recognized a $14,658 non-cash write-off of our goodwill and trade
name associated with our German operation in the first quarter of
2009.




In June
2009, the German government passed additional amendments to the law that became
effective July 23, 2009. The key implication of these amendments to our
business model was to impose additional costs on the doctors and insurance
companies that conduct business with our German operation and disrupt the normal
flow of fitting hearing aids on the first visit to the doctor’s
office.




We are
currently renegotiating contracts in light of the new legislative requirements
and are working to contract with other insurance companies as well. The lack of
signed insurance contracts, the imposition of new and costly requirements on the
ENT doctors and the insurance companies, as well as the uncertainty of
regulatory requirements, will continue to impact our German business. Final
regulatory requirements are expected to be completed during the second quarter
2010, the impact of which is uknown at this time. Germany represented 67%
and 78% of Europe segment revenues and 71% and 89% (excluding first quarter 2009
impairment charges) of Europe segment operating profit for the quarter ended
March 31, 2010 and 2009, respectively.




ITEM
      4.
            RESERVED




ITEM
      6.
            EXHIBITS




(a)
Exhibits required to be filed by Item 601 of Regulation S-K:




Exhibit #
                  
                  Description3.1
                  
                  Amended
      Articles of Incorporation of the registrant (filed on our Form 8-K on
      March 26, 2010 and incorporated by reference herein).10.1
                  
                  Second
      amendment to the amended and restated line of credit agreement with
      Silicon Valley Bank (filed on our Form 8-K on March 15, 2010 and
      incorporated by reference herein).22.1
                  
                  2010
      Proxy voting results of security holders (filed on our Form 8-K on
      May 11, 2010 and incorporated by reference herein).31.1
                  
                  Certification
      of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley
      Act of 2002.31.2
                  
                  Certification
      of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley
      Act of 2002.32
                  
                  Certification
      of Chief Executive Officer and Chief Financial Officer Pursuant to 18
      U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act
      of 2002.




26


SIGNATURE




Pursuant
to the requirements of the Securities Exchange Act of 1934, the registrant has
duly caused this report to be signed on its behalf by the undersigned thereunto
duly authorized.




Date: May
13, 2010




/s/    MichaelM.
      HalloranMichael
      M. HalloranVice President and Chief Financial Officer




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