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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-Q



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



FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2005



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



Commission File No. 000-30335



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SONIC INNOVATIONS, INC.

(Exact name of registrant as specified in its charter)



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



2795 East Cottonwood
Parkway, Suite 660

Salt Lake City, UT 84121-7036

(Address of principal executive offices)



(801) 365-2800

(Registrants telephone number, including area code)



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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 is an accelerated filer (as defined in Rule
12b-2 of the Exchange Act). x Yes ̈No



As of August 1, 2005, there were 21,443,966
shares of the registrants $0.001 par value common stock outstanding.



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##### Table of Contents

SONIC INNOVATIONS, INC.

TABLE OF CONTENTS



|                              |  |                                                                                                           |  |     
|----------------------------- |  | --------------------------------------------------------------------------------------------------------- |  | ----
|                              |  |                                                                                                           |  | Page
|PART I. FINANCIAL INFORMATION |  |                                                                                                          
|                              |  |                                                                                                          
|ITEM 1.                       |  | Condensed Consolidated Financial Statements (Unaudited):                                                  |  |     
|                              |  |                                                                                                          
|                              |  | Condensed Consolidated Balance Sheets as of June 30, 2005 and December 31, 2004                           |  | 3   
|                              |  |                                                                                                          
|                              |  | Condensed Consolidated Statements of Operations for the Three and Six Months Ended June 30, 2005 and 2004 |  | 4   
|                              |  |                                                                                                          
|                              |  | Condensed Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2005 and 2004           |  | 5   
|                              |  |                                                                                                          
|                              |  | Notes to Condensed Consolidated Financial Statements                                                      |  | 6   
|                              |  |                                                                                                          
|ITEM 2.                       |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                     |  | 12  
|                              |  |                                                                                                          
|ITEM 3.                       |  | Quantitative and Qualitative Disclosures about Market Risks                                               |  | 21  
|                              |  |                                                                                                          
|ITEM 4.                       |  | Controls and Procedures                                                                                   |  | 21  
|                              | 
|PART II. OTHER INFORMATION    |  |                                                                                                          
|                              |  |                                                                                                          
|ITEM 4.                       |  | Submission of Matters to a Vote of Security Holders                                                       |  | 22  
|                              |  |                                                                                                          
|ITEM 6.                       |  | Exhibits                                                                                                  |  | 22  
|                              | 
|SIGNATURE                     |  | 23                                                                                                       
|                              | 
|CERTIFICATIONS                |  |                                                                                                          



2



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##### Table of Contents

PART I. FINANCIAL INFORMATION



|ITEM 1. | CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
|------- | -------------------------------------------------------



SONIC INNOVATIONS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands)

(unaudited)



|                                                                                 |  |               |         |   |                   |   |         |  
|-------------------------------------------------------------------------------- |  | ------------- | ------- | - | ----------------- | - | ------- | -
|                                                                                 |  | June 30, 2005 |         |   | December 31, 2004 |  
|ASSETS                                                                           |  |               |         |   |                   |   |         |  
|Current assets:                                                                  |  |               |         |   |                   |   |         |  
|Cash and cash equivalents                                                        |  | $             | 6,622   |   |                   | $ | 8,221   |  
|Marketable securities                                                            |  |               | 5,952   |   |                   |   | 10,482  |  
|Restricted cash, cash equivalents and marketable securities                      |  |               | 11,151  |   |                   |   | 10,571  |  
|Accounts receivable, net of allowance for doubtful accounts of $1,565 and $1,617 |  |               | 18,374  |   |                   |   | 16,092  |  
|Inventories                                                                      |  |               | 12,272  |   |                   |   | 9,799   |  
|Prepaid expenses and other                                                       |  |               | 3,008   |   |                   |   | 2,969   |  
|                                                                                 |  |               |         |   |                   |   |         |  
|Total current assets                                                             |  |               | 57,379  |   |                   |   | 58,134  |  
|Long-term marketable securities                                                  |  |               |        |   |                   |   | 2,321   |  
|Restricted long-term marketable securities                                       |  |               |        |   |                   |   | 754     |  
|Property and equipment, net of accumulated depreciation of $14,421 and $13,097   |  |               | 9,619   |   |                   |   | 10,086  |  
|Goodwill and indefinite-lived intangible assets                                  |  |               | 34,893  |   |                   |   | 34,972  |  
|Definite-lived intangible assets, net                                            |  |               | 6,471   |   |                   |   | 7,328   |  
|Other assets                                                                     |  |               | 1,600   |   |                   |   | 1,691   |  
|                                                                                 |  |               |         |   |                   |   |         |  
|Total assets                                                                     |  | $             | 109,962 |   |                   | $ | 115,286 |  
|                                                                                 |  |               |         |   |                   |   |         |  
|LIABILITIES AND SHAREHOLDERS EQUITY                                             |  |               |         |   |                   |   |         |  
|Current liabilities:                                                             |  |               |         |   |                   |   |         |  
|Current portion of loan payable and line of credit                               |  | $             | 1,846   |   |                   | $ | 1,364   |  
|Payables to former owners of acquired businesses                                 |  |               | 6,013   |   |                   |   | 3,627   |  
|Accounts payable                                                                 |  |               | 8,186   |   |                   |   | 8,315   |  
|Accrued payroll and related expenses                                             |  |               | 3,424   |   |                   |   | 3,085   |  
|Accrued warranty                                                                 |  |               | 4,692   |   |                   |   | 4,526   |  
|Deferred revenue                                                                 |  |               | 3,398   |   |                   |   | 5,455   |  
|Other accrued liabilities                                                        |  |               | 5,852   |   |                   |   | 5,419   |  
|                                                                                 |  |               |         |   |                   |   |         |  
|Total current liabilities                                                        |  |               | 33,411  |   |                   |   | 31,791  |  
|Loan payable, net of current portion                                             |  |               | 5,730   |   |                   |   | 7,161   |  
|Deferred revenue, net of current portion                                         |  |               | 4,023   |   |                   |   | 4,444   |  
|Other liabilities                                                                |  |               | 593     |   |                   |   | 787     |  
|                                                                                 |  |               |         |   |                   |   |         |  
|Total liabilities                                                                |  |               | 43,757  |   |                   |   | 44,183  |  
|Shareholders equity:                                                            |  |               |         |   |                   |   |         |  
|Common stock                                                                     |  |               | 22      |   |                   |   | 22      |  
|Additional paid-in capital                                                       |  |               | 120,229 |   |                   |   | 118,135 |  
|Deferred stock-based compensation                                                |  |               | (1,459  | ) |                   |   | (8      | )
|Accumulated deficit                                                              |  |               | (54,011 | ) |                   |   | (50,797 | )
|Accumulated other comprehensive income                                           |  |               | 5,197   |   |                   |   | 7,524   |  
|Treasury stock, at cost                                                          |  |               | (3,773  | ) |                   |   | (3,773  | )
|                                                                                 |  |               |         |   |                   |   |         |  
|Total shareholders equity                                                       |  |               | 66,205  |   |                   |   | 71,103  |  
|                                                                                 |  |               |         |   |                   |   |         |  
|Total liabilities and shareholders equity                                       |  | $             | 109,962 |   |                   | $ | 115,286 |  
|                                                                                 |  |               |         |   |                   |   |         |  



See accompanying notes
to condensed consolidated financial statements.



3



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##### Table of Contents

SONIC INNOVATIONS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(unaudited)



|                                                      |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |        |  
|----------------------------------------------------- |  | -------------------------- | ------ | - | ------------------------ | - | ------ | ---- |  | - | ------ | - |  | - | ------ | -
|                                                      |  | Three months endedJune 30, |        |   | Six months endedJune 30, |  
|                                                      |  | 2005                       |        |   | 2004                     |   |        | 2005 |  |   | 2004   |  
|Net sales                                             |  | $                          | 30,185 |   |                          | $ | 24,338 |      |  | $ | 56,076 |   |  | $ | 50,644 |  
|Cost of sales                                         |  |                            | 13,419 |   |                          |   | 10,663 |      |  |   | 25,453 |   |  |   | 22,392 |  
|                                                      |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |        |  
|Gross profit                                          |  |                            | 16,766 |   |                          |   | 13,675 |      |  |   | 30,623 |   |  |   | 28,252 |  
|Selling, general and administrative expense           |  |                            | 14,660 |   |                          |   | 10,562 |      |  |   | 29,514 |   |  |   | 20,606 |  
|Research and development expense                      |  |                            | 2,136  |   |                          |   | 2,346  |      |  |   | 4,488  |   |  |   | 4,900  |  
|                                                      |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |        |  
|Operating profit (loss)                               |  |                            | (30    | ) |                          |   | 767    |      |  |   | (3,379 | ) |  |   | 2,746  |  
|Other income (expense), net                           |  |                            | 128    |   |                          |   | (29    | )    |  |   | 88     |   |  |   | (78    | )
|                                                      |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |        |  
|Income (loss) before income taxes                     |  |                            | 98     |   |                          |   | 738    |      |  |   | (3,291 | ) |  |   | 2,668  |  
|Provision (benefit) for income taxes                  |  |                            | (165   | ) |                          |   | 114    |      |  |   | (77    | ) |  |   | 456    |  
|                                                      |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |        |  
|Net income (loss)                                     |  | $                          | 263    |   |                          | $ | 624    |      |  | $ | (3,214 | ) |  | $ | 2,212  |  
|                                                      |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |        |  
|Earnings (loss) per common share:                     |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |        |  
|Basic                                                 |  | $                          | 0.01   |   |                          | $ | 0.03   |      |  | $ | (0.15  | ) |  | $ | 0.11   |  
|                                                      |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |        |  
|Diluted                                               |  | $                          | 0.01   |   |                          | $ | 0.03   |      |  | $ | (0.15  | ) |  | $ | 0.10   |  
|                                                      |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |        |  
|Weighted average number of common shares outstanding: |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |        |  
|Basic                                                 |  |                            | 21,289 |   |                          |   | 20,682 |      |  |   | 21,252 |   |  |   | 20,545 |  
|                                                      |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |        |  
|Diluted                                               |  |                            | 21,984 |   |                          |   | 22,775 |      |  |   | 21,252 |   |  |   | 22,783 |  
|                                                      |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |        |  



See accompanying notes
to condensed consolidated financial statements.



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SONIC INNOVATIONS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)



|                                                                                                   |  |                          |        |   |      |   |        |  
|-------------------------------------------------------------------------------------------------- |  | ------------------------ | ------ | - | ---- | - | ------ | -
|                                                                                                   |  | Six months endedJune 30, |       
|                                                                                                   |  | 2005                     |        |   | 2004 |  
|Cash flows from operating activities:                                                              |  |                          |        |   |      |   |        |  
|Net income (loss)                                                                                  |  | $                        | (3,214 | ) |      | $ | 2,212  |  
|Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: |  |                          |        |   |      |   |        |  
|Depreciation and amortization                                                                      |  |                          | 2,767  |   |      |   | 1,583  |  
|Stock-based compensation                                                                           |  |                          | 159    |   |      |   | 14     |  
|Foreign currency losses                                                                            |  |                          | 498    |   |      |   | 196    |  
|Changes in assets and liabilities:                                                                 |  |                          |        |   |      |   |        |  
|Accounts receivable, net                                                                           |  |                          | (3,617 | ) |      |   | 1,280  |  
|Inventories                                                                                        |  |                          | (3,105 | ) |      |   | 309    |  
|Prepaid expenses and other                                                                         |  |                          | (234   | ) |      |   | (857   | )
|Other assets                                                                                       |  |                          | (226   | ) |      |   | 338    |  
|Accounts payable, accrued liabilities and deferred revenue                                         |  |                          | (2,102 | ) |      |   | (800   | )
|                                                                                                   |  |                          |        |   |      |   |        |  
|Net cash provided by (used in) operating activities                                                |  |                          | (9,074 | ) |      |   | 4,275  |  
|Cash flows from investing activities:                                                              |  |                          |        |   |      |   |        |  
|Payments related to acquisitions of businesses and intangibles                                     |  |                          | (1,047 | ) |      |   | (1,600 | )
|Purchases of property and equipment                                                                |  |                          | (1,730 | ) |      |   | (2,606 | )
|Investments and advances, net                                                                      |  |                          | 348    |   |      |   | 193    |  
|Proceeds from (purchases of) marketable securities, net                                            |  |                          | 6,851  |   |      |   | (949   | )
|                                                                                                   |  |                          |        |   |      |   |        |  
|Net cash provided by (used in) investing activities                                                |  |                          | 4,422  |   |      |   | (4,962 | )
|Cash flows from financing activities:                                                              |  |                          |        |   |      |   |        |  
|Principal payments on loan payable                                                                 |  |                          | (644   | ) |      |   | (613   | )
|Proceeds from borrowings on line of credit, net                                                    |  |                          | 639    |   |      |   |       |  
|Decrease in restricted cash, cash equivalents and marketable securities, net                       |  |                          | 174    |   |      |   | 124    |  
|Proceeds from pre-acquisition receivables payable to previous owners of acquired business, net     |  |                          | 2,979  |   |      |   | 1,322  |  
|Proceeds from exercise of stock options and employee stock purchases                               |  |                          | 484    |   |      |   | 2,169  |  
|                                                                                                   |  |                          |        |   |      |   |        |  
|Net cash provided by financing activities                                                          |  |                          | 3,632  |   |      |   | 3,002  |  
|Effect of exchange rate changes on cash and cash equivalents                                       |  |                          | (579   | ) |      |   | (218   | )
|                                                                                                   |  |                          |        |   |      |   |        |  
|Net increase (decrease) in cash and cash equivalents                                               |  |                          | (1,599 | ) |      |   | 2,097  |  
|Cash and cash equivalents, beginning of the period                                                 |  |                          | 8,221  |   |      |   | 8,630  |  
|                                                                                                   |  |                          |        |   |      |   |        |  
|Cash and cash equivalents, end of the period                                                       |  | $                        | 6,622  |   |      | $ | 10,727 |  
|                                                                                                   |  |                          |        |   |      |   |        |  
|Supplemental cash flow information:                                                                |  |                          |        |   |      |   |        |  
|Cash paid for interest                                                                             |  | $                        | 138    |   |      | $ | 121    |  
|Cash paid for income taxes                                                                         |  |                          | 1,081  |   |      |   | 1,230  |  



See accompanying notes
to condensed consolidated financial statements.



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##### Table of Contents

SONIC INNOVATIONS, 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 accounting principles generally accepted in the United States of America 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
presentation have been included. The results of operations for the three and six months ended June 30, 2005 are not necessarily indicative of results that may be expected for the full year ending December 31, 2005. For further information, refer to
the consolidated financial statements and footnotes thereto included in the Companys Annual Report on Form 10-K for the year ended December 31, 2004 as filed with the Securities and Exchange Commission.



Principles of Consolidation.The consolidated financial statements include the
accounts of Sonic Innovations, Inc. and its wholly owned subsidiaries. All intercompany balances and transactions are eliminated in consolidation.



Use of Estimates.The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America 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, long-lived asset impairment, warranty accruals and deferred
income tax asset valuation allowances. Actual results could differ from those estimates.



Revenue Recognition and Concentrations of Credit Risk.Sales are recognized when (i) products are shipped, except for hearing aid retail 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 and determinable, (v) contractual obligations have been satisfied, and (vi) collectability is reasonably assured. Net sales consist
of product sales less provisions for sales returns, which are made at the time of sale. Revenues related to sales of separately priced extended service contracts are deferred and recognized on a straight-line basis over the contractual periods. The
Company performs ongoing credit evaluations of its customers and provides for doubtful accounts. No single customer comprised more than 10% of (i) net sales in the three and six months ended June 30, 2005 and 2004 or (ii) accounts receivable as of
June 30, 2005 and December 31, 2004. The Company generally has a 60-day return policy, 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:



|                             |  |                             |        |   |                           |   |        |      |  |   |        |   |  |   |        |  
|---------------------------- |  | --------------------------- | ------ | - | ------------------------- | - | ------ | ---- |  | - | ------ | - |  | - | ------ | -
|                             |  | Three months ended June 30, |        |   | Six months ended June 30, |  
|                             |  | 2005                        |        |   | 2004                      |   |        | 2005 |  |   | 2004   |  
|Balance, beginning of period |  | $                           | 2,858  |   |                           | $ | 3,151  |      |  | $ | 2,815  |   |  | $ | 3,487  |  
|Provisions                   |  |                             | 5,355  |   |                           |   | 2,888  |      |  |   | 8,130  |   |  |   | 6,039  |  
|Returns processed            |  |                             | (4,325 | ) |                           |   | (3,225 | )    |  |   | (7,057 | ) |  |   | (6,712 | )
|                             |  |                             |        |   |                           |   |        |      |  |   |        |   |  |   |        |  
|Balance, end of period       |  | $                           | 3,888  |   |                           | $ | 2,814  |      |  | $ | 3,888  |   |  | $ | 2,814  |  
|                             |  |                             |        |   |                           |   |        |      |  |   |        |   |  |   |        |  



Warranty Costs.The Company
provides for the cost of remaking and repairing products under warranty at the time of sale. These costs are included in cost of sales. When evaluating the adequacy of the warranty accrual, 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.



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Accrued warranty costs were as follows:



|                             |  |                             |        |   |                           |   |        |      |  |   |        |   |  |   |        |  
|---------------------------- |  | --------------------------- | ------ | - | ------------------------- | - | ------ | ---- |  | - | ------ | - |  | - | ------ | -
|                             |  | Three months ended June 30, |        |   | Six months ended June 30, |  
|                             |  | 2005                        |        |   | 2004                      |   |        | 2005 |  |   | 2004   |  
|Balance, beginning of period |  | $                           | 4,300  |   |                           | $ | 4,072  |      |  | $ | 4,526  |   |  | $ | 4,115  |  
|Provisions                   |  |                             | 1,679  |   |                           |   | 1,001  |      |  |   | 2,673  |   |  |   | 1,990  |  
|Costs incurred               |  |                             | (1,287 | ) |                           |   | (1,014 | )    |  |   | (2,507 | ) |  |   | (2,046 | )
|                             |  |                             |        |   |                           |   |        |      |  |   |        |   |  |   |        |  
|Balance, end of period       |  | $                           | 4,692  |   |                           | $ | 4,059  |      |  | $ | 4,692  |   |  | $ | 4,059  |  
|                             |  |                             |        |   |                           |   |        |      |  |   |        |   |  |   |        |  



Derivative Instruments.The
Company enters into readily marketable forward contracts with financial institutions to minimize the short-term impact of foreign currency fluctuations on certain intercompany balances. The Company does 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. The Companys foreign exchange forward
contracts mature in three months or less from the contract date. On June 30, 2005, the Company entered into forward contracts for $1,147 (1,400 Canadian dollars), $3,440 (2,830 Euro), $957 (530 British pounds sterling) and $4,533 (6,000 Australian
dollars), all of which expire on September 30, 2005.



Marketable Securities.The Company designates the classification of its marketable securities at the time of purchase and re-evaluates this designation as of each balance sheet date. As of June 30, 2005 and December 31, 2004, the Companys investment portfolio
consisted of corporate debt securities classified as held-to-maturity and was presented at its amortized cost, which approximated market value. The amortized cost of corporate debt securities is adjusted for amortization of premiums and accretion of
discounts to maturity. If a decline in the market value below cost that is deemed other than temporary were to occur, the decline would be included in the results of operations resulting in the establishment of a new cost basis. For the three and
six months ended June 30, 2005 and 2004, the Company did not experience any declines in market value which were deemed other than temporary.



Comprehensive Income (Loss).The Companys comprehensive income (loss) consisted of net income (loss) plus changes in foreign currency translation
adjustments, which were not adjusted for income taxes as they relate to specific indefinite investments in subsidiaries, as follows:



|                                         |  |                            |        |   |                          |   |      |      |  |   |        |   |  |   |        |  
|---------------------------------------- |  | -------------------------- | ------ | - | ------------------------ | - | ---- | ---- |  | - | ------ | - |  | - | ------ | -
|                                         |  | Three months endedJune 30, |        |   | Six months endedJune 30, |  
|                                         |  | 2005                       |        |   | 2004                     |   |      | 2005 |  |   | 2004   |  
|Net income (loss)                        |  | $                          | 263    |   |                          | $ | 624  |      |  | $ | (3,214 | ) |  | $ | 2,212  |  
|Foreign currency translation adjustments |  |                            | (1,209 | ) |                          |   | (804 | )    |  |   | (2,327 | ) |  |   | (1,142 | )
|                                         |  |                            |        |   |                          |   |      |      |  |   |        |   |  |   |        |  
|Comprehensive income (loss)              |  | $                          | (946   | ) |                          | $ | (180 | )    |  | $ | (5,541 | ) |  | $ | 1,070  |  
|                                         |  |                            |        |   |                          |   |      |      |  |   |        |   |  |   |        |  



Stock-Based Compensation.The
Company maintains various stock-based compensation programs and accounts for these programs under the recognition and measurement principles of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees
(APB 25) and related interpretations. No compensation expense is recognized for (i) employee stock option grants because all options granted had an exercise price equal to the market value of the underlying common stock on the date of
grant and (ii) the discount associated with the employee stock purchase program because it is not considered compensatory.



The Company granted 63 and 373 unvested shares of common stock to employees valued at $255 and $1,724, respectively in the three and six months ended June 30, 2005,
respectively, the cost of which is being amortized on a straight-line basis over the vesting period.



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The following table illustrates the effect on net income (loss) and earnings (loss) per share if the Company had applied
the fair market value recognition provisions of Statement of Financial Standards (SFAS) No. 123 Accounting for Stock-Based Compensation in calculating its stock-based compensation expense.



|                                                                                         |  |                            |      |   |                          |   |       |      |  |   |        |   |  |   |        |  
|---------------------------------------------------------------------------------------- |  | -------------------------- | ---- | - | ------------------------ | - | ----- | ---- |  | - | ------ | - |  | - | ------ | -
|                                                                                         |  | Three months endedJune 30, |      |   | Six months endedJune 30, |  
|                                                                                         |  | 2005                       |      |   | 2004                     |   |       | 2005 |  |   | 2004   |  
|Net income (loss) as reported                                                            |  | $                          | 263  |   |                          | $ | 624   |      |  | $ | (3,214 | ) |  | $ | 2,212  |  
|Add: Stock-based employee compensation included in reported net income (loss)            |  |                            | 95   |   |                          |   | 7     |      |  |   | 159    |   |  |   | 14     |  
|Deduct: Stock-based employee compensation expense determined under the fair value method |  |                            | (222 | ) |                          |   | (925  | )    |  |   | (592   | ) |  |   | (1,844 | )
|                                                                                         |  |                            |      |   |                          |   |       |      |  |   |        |   |  |   |        |  
|Pro forma net income (loss)                                                              |  | $                          | 136  |   |                          | $ | (294  | )    |  | $ | (3,647 | ) |  | $ | 382    |  
|                                                                                         |  |                            |      |   |                          |   |       |      |  |   |        |   |  |   |        |  
|Basic earnings (loss) per common share as reported                                       |  | $                          | 0.01 |   |                          | $ | 0.03  |      |  | $ | (0.15  | ) |  | $ | 0.11   |  
|                                                                                         |  |                            |      |   |                          |   |       |      |  |   |        |   |  |   |        |  
|Diluted earnings (loss) per common share as reported                                     |  | $                          | 0.01 |   |                          | $ | 0.03  |      |  | $ | (0.15  | ) |  | $ | 0.10   |  
|                                                                                         |  |                            |      |   |                          |   |       |      |  |   |        |   |  |   |        |  
|Pro forma basic and diluted earnings (loss) per common share                             |  | $                          | 0.01 |   |                          | $ | (0.01 | )    |  | $ | (0.17  | ) |  | $ | 0.02   |  
|                                                                                         |  |                            |      |   |                          |   |       |      |  |   |        |   |  |   |        |  



Earnings (Loss) Per Common Share.Basic earnings (loss) per common share is calculated based upon the weighted average shares of common stock outstanding during the period. Diluted earnings 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. Anti-dilutive common sock equivalents are not considered in the calculation. The number of common stock equivalents, their dilution effect
and the number of anti-dilutive common stock equivalents were as follows:



|                                            |  |                            |  |                          |  |       |  |      
|------------------------------------------- |  | -------------------------- |  | ------------------------ |  | ----- |  | -----
|                                            |  | Three months endedJune 30, |  | Six months endedJune 30,
|                                            |  | 2005                       |  | 2004                     |  | 2005  |  | 2004 
|Common stock equivalents                    |  | 2,294                      |  | 4,226                    |  |      |  | 4,348
|Dilutive effect of common stock equivalents |  | 695                        |  | 2,093                    |  |      |  | 2,238
|Anti-dilutive common stock equivalents      |  | 2,322                      |  | 186                      |  | 4,634 |  | 180  



New Accounting Pronouncements.In November 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 151, Inventory Costsan amendment of ARB No. 43, Chapter 4, which clarifies that abnormal inventory costs such as costs of idle
facilities, excess freight and handling costs and wasted materials (spoilage) are required to be recognized as current period charges. SFAS No. 151 is effective for fiscal years beginning after June 15, 2005. The Company is currently evaluating the
provisions of SFAS No. 151 and does not believe that the adoption will have a material effect on its results of operations and financial position.



In December 2004, the FASB issued SFAS No. 123R, Share-Based Payment, which requires all share-based payments to employees, including grants of employee stock
options, to be recognized as an expense. The value is recognized over the requisite service period based on fair values measured on grant dates. The new standard may be adopted using either the modified prospective method or the modified
retrospective method. In March 2005, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin (SAB) No. 107, Share-Based Payment, which clarified the SECs expectations with regard to the
assumptions underlying the fair value estimates of options. In April 2005, the SEC amended the compliance dates for SFAS No. 123R such that the new standard will be effective for the Company beginning January 1, 2006. The Company is currently
evaluating its share-based employee compensation programs, the potential effect of these statements on its results of operations and financial position and the alternative adoption methods.



In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error
Corrections, which replaces APB Opinion No. 20, Accounting Changes, and SFAS No. 3, Reporting Accounting Changes in Interim Financial Statements, and requires that a voluntary change in accounting principle be applied
retrospectively to all prior period financial statements presented, unless it is impracticable to do so. SFAS No. 154 also provides that a change in method of depreciating or amortizing a long-lived non-financial asset be accounted for as a change
in estimate effected by a change in accounting principle, and also provides that correction of errors in previously issued financial statements should be termed a restatement. SFAS No. 154 is effective for fiscal years beginning after
December 15, 2005. The Company does not believe the adoption of SFAS No. 154 will have a material effect on its results of operations and financial position.



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2. ACQUISITIONS



Tympany, Inc. (Tympany). In December 2004, the Company acquired 100% of the stock of Tympany, the developer of the Otogram, a machine that automates
the four most commonly performed tests for diagnosing hearing loss.



The
initial purchase price of $2,262, including expenses of $254, consisted of $1,200 in cash and 196 shares of the Companys common stock valued at $808 based on the average closing price of the common stock for the period beginning two days
before and ending two days after the closing of the transaction. In addition, a $500 loan made by the Company to Tympany prior to the acquisition was recorded as additional consideration. Contingent consideration will be paid based on the following
schedule: 2005  35% of net 2005 Tympany revenue, plus 10% of net 2005 hearing aid sales less a base amount; 2006  35% of net 2006 Tympany revenue, plus 10% of net 2006 hearing aid sales less 105% of a base amount; and 2007  20% of
the lesser of 2007 or 2006 net Tympany revenue, plus 35% of any excess of 2007 net Tympany revenue over 2006 net Tympany revenue, plus 10% of net 2007 hearing aid sales less 110% of a base amount. Payments will be made semi-annually in a combination
of cash (60%) and Company common stock (40%). As of June 30, 2005, the Company recorded additional purchase price under this contingent consideration arrangement based on the Companys interpretation of the contract. The balance due the former
owners as of June 30, 2005 was $690. The results of operations of Tympany are included in the results of operations of the Company from December 1, 2004.



The following table sets forth summary pro forma condensed consolidated financial information as if the acquisition had taken place at the beginning of
the periods presented:



|                                                      |  |                                 |        |   |                               |   |        |  
|----------------------------------------------------- |  | ------------------------------- | ------ | - | ----------------------------- | - | ------ | -
|                                                      |  | Three months endedJune 30, 2004 |        |   | Six months endedJune 30, 2004 |  
|Net sales                                             |  | $                               | 25,050 |   |                               | $ | 51,773 |  
|Operating loss                                        |  |                                 | (823   | ) |                               |   | (52    | )
|Net loss                                              |  |                                 | (975   | ) |                               |   | (637   | )
|Loss per common share:                                |  |                                 |        |   |                               |   |        |  
|Basic and diluted                                     |  | $                               | (0.05  | ) |                               | $ | (0.03  | )
|                                                      |  |                                 |        |   |                               |   |        |  
|Weighted average number of common shares outstanding: |  |                                 |        |   |                               |   |        |  
|Basic and diluted                                     |  |                                 | 20,878 |   |                               |   | 20,741 |  
|                                                      |  |                                 |        |   |                               |   |        |  



Under the terms of the Tympany
purchase agreement, the Company is required to pay the first $250 of any losses incurred in connection with a lawsuit filed by Tympanys former contract manufacturer, and any losses in excess of $250 would be shared equally between the Company
and Tympanys former owners. During the second quarter 2005, the lawsuit was settled for $875, of which Tympanys former owners were responsible for $313. The Company recorded goodwill of $562 pertaining to this settlement.



Sanomed Handelsgesellschaft mbH (Sanomed). In May 2003, the Company
acquired 100% of the stock of Sanomed, a distribution company that markets hearing aids directly to German hearing impaired customers through ear-nose-throat (ENT) physicians. Under the terms of the purchase agreement, contingent consideration in
the form of an earn-out of (i) $1,508 was accrued as of June 30, 2005 based on achievement of targeted net sales for the one year period ended May 31, 2005 and (ii) $1,556 was paid in 2004 based on achievement of targeted net sales for the one year
period ended May 31, 2004. Additional contingent consideration of up to a maximum of $1,810 may be payable based on achieving targeted sales performance for the one year period ending May 31, 2006. Under the terms of the purchase agreement, the
Company is required to remit to the former owners of Sanomed any money collected on certain accounts receivable that were deemed uncollectible prior to the acquisition. As of June 30, 2005, the Company had collected $9,564 of such accounts
receivable, and the net after tax amount of $5,738 will be remitted to the former owners in 2005, of which $3,815 remains unremitted as of June 30, 2005.



In May 2004, the Company acquired 100% of the stock of a Switzerland-based hearing aid retail chain. Contingent consideration in the form of an earn-out of 225 CHF ($175)
was paid in the second quarter 2005 based on sales performance for the one year period ended April 30, 2005.



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3. INVENTORIES



Inventories are stated at the lower of cost or market value using the first-in, first-out method and were as follows:



|                |  |               |        |                   |   |      
|--------------- |  | ------------- | ------ | ----------------- | - | -----
|                |  | June 30, 2005 |        | December 31, 2004
|Raw materials   |  | $             | 3,876  |                   | $ | 2,863
|Components      |  |               | 2,944  |                   |   | 1,960
|Work-in-process |  |               | 205    |                   |   | 117  
|Finished goods  |  |               | 5,247  |                   |   | 4,859
|                |  |               |        |                   |   |      
|Total           |  | $             | 12,272 |                   | $ | 9,799
|                |  |               |        |                   |   |      



4. INTANGIBLE ASSETS



Goodwill and indefinite-lived intangible assets were as follows:



|                                                              |  |                                |        |  
|------------------------------------------------------------- |  | ------------------------------ | ------ | -
|                                                              |  | Six months ended June 30, 2005 |       
|Balance, beginning of period                                  |  | $                              | 34,972 |  
|Additional purchase price consideration and transaction costs |  |                                | 2,645  |  
|Effects of foreign currency fluctuations                      |  |                                | (2,274 | )
|                                                              |  |                                |        |  
|Balance, end of period                                        |  | $                              | 34,893 |  
|                                                              |  |                                |        |  



Definite-lived intangible assets were
as follows:



|                                             |  |              |  |                       |       |                          |   |                       |  |                          |       |  |   |      
|-------------------------------------------- |  | ------------ |  | --------------------- | ----- | ------------------------ | - | --------------------- |  | ------------------------ | ----- |  | - | -----
|                                             |  |              |  | June 30, 2005         |       | December 31, 2004       
|                                             |  | Useful Lives |  | Gross Carrying Amount |       | Accumulated Amortization |   | Gross Carrying Amount |  | Accumulated Amortization
|Purchased technology and technology licenses |  | 3-13 years   |  | $                     | 3,883 |                          | $ | 960                   |  | $                        | 3,633 |  | $ | 570  
|Brand names                                  |  | 3-15 years   |  |                       | 3,060 |                          |   | 732                   |  |                          | 3,373 |  |   | 624  
|Non-compete agreements                       |  | 5 years      |  |                       | 790   |                          |   | 218                   |  |                          | 843   |  |   | 153  
|Customer databases                           |  | 2-5 years    |  |                       | 727   |                          |   | 202                   |  |                          | 769   |  |   | 131  
|Distribution agreements                      |  | 2-5 years    |  |                       | 320   |                          |   | 277                   |  |                          | 357   |  |   | 274  
|Software and other intangibles               |  | 1-5 years    |  |                       | 223   |                          |   | 143                   |  |                          | 227   |  |   | 122  
|                                             |  |              |  |                       |       |                          |   |                       |  |                          |       |  |   |      
|Total                                        |  |              |  | $                     | 9,003 |                          | $ | 2,532                 |  | $                        | 9,202 |  | $ | 1,874
|                                             |  |              |  |                       |       |                          |   |                       |  |                          |       |  |   |      



Amortization expense for
definite-lived intangible assets is calculated using the straight-line method over the estimated useful lives of the assets. Estimated annual amortization expense for the years 2005 through 2009 is as follows: remaining 2005 - $611; 2006 - $1,157;
2007 - $1,058; 2008 - $869; and 2009 - $787.



5. LOAN PAYABLE AND LINE OF
CREDIT



The Company obtained a loan from a German bank in 2003 to fund the
acquisition of Sanomed. As of June 30, 2005, the balance of the loan was 5,750 Euro ($6,937). The interest rate applicable to the loan is 1.0% above the EURIBOR rate (2.29% as of June 30, 2005). The loan is collateralized by a letter of credit from
a U.S. bank, and the Company pledged certain amounts of its cash, cash equivalents and marketable securities as security to obtain a reduced interest rate of 0.6% on this letter of credit. The loan payments are 250 Euro ($302) per quarter. The
effective interest rates on this loan for the six months ended June 30, 2005 and 2004 were 3.92% and 3.84%, respectively.



During the second quarter 2005, the Company procured a line of credit from a financial institution. As of June 30, 2005, $639 was outstanding under the line,
collateralized by $711 of marketable securities on deposit with the financial institution. Interest on the loan is based on LIBOR and the amount of the pledged collateral as defined in the agreement, and the interest rate was 4.70% as of June 30,
2005. The line is limited by the value of the securities collateralizing the line of credit.



6. SEGMENT INFORMATION



The Company is
a hearing healthcare company that designs, develops, manufactures and markets advanced digital hearing aids and proprietary auditory testing equipment. The Company conducts business globally and is managed geographically. Based on established
criteria, the Company has three reportable segments: North America, Europe and Rest-of-world. Sales



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and gross profit are attributed to a segment based on the ordering location of the customer. The Companys Chief Executive Officer and senior management
rely on internal management reports that provide financial and operational information by geographic location. The Companys management makes financial decisions and allocates resources based hearing aid on the information it receives from
these internal management reports. These reports reflect selling profit, which is defined as sales less manufactured cost of sales less location operating expenses. The Company does not allocate research and development expenses to its segments. In
prior interim periods, the Company reflected manufacturing profit and all U.S.-based research and development expense in the North America segment.



The Company has reclassified previous period amounts to reflect the current period presentation.



|                                                |  |               |        |   |        |   |               |  |             |        |  |       |        |   |  |   |         |  
|----------------------------------------------- |  | ------------- | ------ | - | ------ | - | ------------- |  | ----------- | ------ |  | ----- | ------ | - |  | - | ------- | -
|                                                |  | North America |        |   | Europe |   | Rest-of-world |  | Unallocated |        |  | Total |       
|Three months ended June 30, 2005                |  |               |        |   |        |   |               |  |             |        |  |       |        |   |  |   |         |  
|Net sales to external customers                 |  | $             | 13,255 |   |        | $ | 11,926        |  | $           | 5,004  |  | $     |       |   |  | $ | 30,185  |  
|Operating profit (loss)                         |  |               | (297   | ) |        |   | 1,929         |  |             | 474    |  |       | (2,136 | ) |  |   | (30     | )
|Three months ended June 30, 2004                |  |               |        |   |        |   |               |  |             |        |  |       |        |   |  |   |         |  
|Net sales to external customers                 |  |               | 9,626  |   |        |   | 10,513        |  |             | 4,199  |  |       |       |   |  |   | 24,338  |  
|Operating profit (loss)                         |  |               | 1,122  |   |        |   | 1,465         |  |             | 526    |  |       | (2,346 | ) |  |   | 767     |  
|Six months ended June 30, 2005                  |  |               |        |   |        |   |               |  |             |        |  |       |        |   |  |   |         |  
|Net sales to external customers                 |  |               | 22,849 |   |        |   | 24,204        |  |             | 9,023  |  |       |       |   |  |   | 56,076  |  
|Operating profit (loss)                         |  |               | (3,354 | ) |        |   | 4,039         |  |             | 424    |  |       | (4,488 | ) |  |   | (3,379  | )
|Six months ended June 30, 2004                  |  |               |        |   |        |   |               |  |             |        |  |       |        |   |  |   |         |  
|Net sales to external customers                 |  |               | 19,231 |   |        |   | 23,097        |  |             | 8,316  |  |       |       |   |  |   | 50,644  |  
|Operating profit (loss)                         |  |               | 2,072  |   |        |   | 4,520         |  |             | 1,054  |  |       | (4,900 | ) |  |   | 2,746   |  
|As of June 30, 2005                             |  |               |        |   |        |   |               |  |             |        |  |       |        |   |  |   |         |  
|Identifiable segment assets                     |  |               | 50,388 |   |        |   | 43,845        |  |             | 15,729 |  |       |       |   |  |   | 109,962 |  
|Goodwill and indefinite-lived intangible assets |  |               | 5,665  |   |        |   | 21,743        |  |             | 7,485  |  |       |       |   |  |   | 34,893  |  
|Long-lived assets                               |  |               | 15,293 |   |        |   | 25,120        |  |             | 10,570 |  |       |       |   |  |   | 50,983  |  
|As of December 31, 2004                         |  |               |        |   |        |   |               |  |             |        |  |       |        |   |  |   |         |  
|Identifiable segment assets                     |  |               | 54,029 |   |        |   | 46,243        |  |             | 15,014 |  |       |       |   |  |   | 115,286 |  
|Goodwill and indefinite-lived intangible assets |  |               | 4,762  |   |        |   | 22,564        |  |             | 7,646  |  |       |       |   |  |   | 34,972  |  
|Long-lived assets                               |  |               | 15,016 |   |        |   | 26,826        |  |             | 10,544 |  |       |       |   |  |   | 52,386  |  



Long-lived assets consist of property
and equipment, definite-lived and indefinite-lived intangible assets and goodwill. The majority of the Companys assets as of June 30, 2005 and December 31, 2004 were attributable to its U.S. operations. In addition to the U.S., the Company
operates in two countries, Germany and Australia, in which assets and net sales were in excess of 10% of consolidated amounts.



7. LEGAL PROCEEDINGS



The Companys wholly owned subsidiary, Tympany, filed a declaratory judgment action in March 2004 against BioCell and International Biophysics Corp. (collectively, IBC) stemming from a dispute
regarding manufacturing services performed by IBC for Tympany. IBC counterclaimed and sought, among other claims, lost profits and punitive damages. The Company settled this lawsuit in the second quarter 2005 by paying IBC $875, of which $313 will
be reimbursed to the Company by the former owners of Tympany.



In July 2005,
Energy Transportation Group, Inc. brought suit in the U.S. District Court for Delaware against a number of hearing aid companies, including the Company, for infringement of one or more claims of two U.S. patents pertaining to programmable digital
hearing aid systems. The lawsuit seeks injunctive relief and damages from the defendants. The Company strongly denies the allegation and will defend itself vigorously; however, litigation is inherently uncertain and there can be no assurance that
the Company will not be materially affected.



From time to time the Company is
subject to legal proceedings, claims and litigation arising in the ordinary course of the business. Most of these legal actions are brought against the Company by others and, when the Company feels it is necessary to protect its stockholders
investment, the Company may bring legal actions itself. Actions can stem from disputes regarding the ownership of intellectual property, customer claims regarding the function or safety of the Companys 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, the Company does not expect that the ultimate resolution



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of any known legal action, other than as described above, will have a material adverse effect on its results of operations and financial position.



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



The following discussion contains forward-looking statements that involve risks and
uncertainties. These statements refer to our future results, plans, objectives, expectations and intentions. These forward-looking statements include statements regarding the following: negative factors impacting hearing aid growth rates today to
decrease in importance in the future; hearing aid prices decreasing in the future; hearing aids becoming smaller, less conspicuous, easier to fit and more comfortable through improvements in technology; more people who could benefit from hearing
aids actually buying hearing aids in the future; significant growth of first time hearing aid purchasers in the future; the market for hearing aids increasing in the future; our platform enabling a broad product line with many price points;
providing more patients for hearing aid retailers; expectations for us to be profitable in the second half 2005; Tympany operations being dilutive for the balance of 2005; decreased North American and European sales in the third quarter 2005 as a
result of vacation schedules and the elimination of Tympany deferred revenue related to an upgrade obligation; North America sales to increase in the fourth quarter of 2005 as new products are introduced; European sales increasing as Innova is
introduced in non-English speaking European markets in the fourth quarter 2005; Rest-of-world sales increasing as Innova sales in Australia increase; gross margin improvement in the second half 2005 due to higher average selling prices, better
overhead absorption, reduced purchased component and assembly costs, lower sales returns, and the elimination of low-margin Tympany deferred revenue; selling, general and administrative expense remaining consistent with the second quarter 2005 level
for the balance of 2005; research and development expense remaining consistent with the second quarter level in the near term but increasing in 2006; other income/expense not being a significant item for the balance of 2005; changes in accounting
treatment contemplated by SFAS No. 123R and SFAS No. 151; financial instrument credit risks; and sufficiency of cash to fund our operations into 2006.



Our actual results could differ materially and adversely from those anticipated in such forward-looking statements. Factors that could contribute to these differences
include, but are not limited to, the risks discussed in the section titled Factors That May Affect Future Performance included elsewhere in this Quarterly Report on Form 10-Q. Our critical accounting policies are described in our Annual
Report on Form 10-K for the year ended December 31, 2004.



OVERVIEW



Sonic Innovations is a hearing healthcare company. We design, develop,
manufacture and market advanced digital hearing aids designed to provide the highest levels of satisfaction for hearing impaired consumers and proprietary auditory testing equipment that automates the four most commonly performed hearing tests.
Capitalizing on what we believe is an advanced understanding of human hearing, we have developed patented digital signal processing technologies and embedded them in our hearing aids. In countries where we have direct (owned) operations, we sell
directly to hearing care professionals, and in several of those countries, we also sell hearing aids directly to hearing impaired consumers. In other parts of the world where we do not have direct operations, we sell principally to distributors.
From our inception, we have focused all our efforts and investment on the therapeutic side of hearing care by developing high-performance digital hearing aids. In December 2004, we acquired Tympany and now offer diagnostic equipment to further help
hearing impaired individuals.



Market



The hearing aid market is large at both the wholesale (manufacturing) level (over $2.0
billion) and the retail level (over $5.0 billion). It is estimated that only 20% of those who could benefit from a hearing aid actually own one. There are many factors that cause this low market penetration rate, such as the cost of hearing aids,
the stigma of wearing hearing aids and the discomfort associated with wearing hearing aids. We believe that these negative factors will decrease in importance in the future because we expect prices will continue to go down for a given level of
performance and technology improvements will result in hearing aids that are less conspicuous, easier to fit and more comfortable. Therefore, in the future, we expect that more people who could benefit from hearing aids will buy them, and we believe
that the growth rate of first time hearing aid purchasers will be significant, particularly as the developed worlds population ages. As a result, we believe the market for hearing aids will increase in the future.



Strategy



Our strategy to gain share in this expanding market is twofold. First, we must develop innovative, technologically superior products. In
late March 2005, we launched a new high-end product line, Innova, which we believe is feature rich and further improves on our best-of-class digital signal processing. Second, we must continue to make progress in non-traditional distribution
channels and with alternative distribution strategies. Our new Innova product platform offers state-of-the-art features and, most importantly, improves upon our two strongest features  noise reduction and directionality. Noise



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reduction allows the hearing aid to reduce background noise so that speech sounds are clearer. We have the only omni-directional hearing aid that has been
clinically proven to improve speech intelligibility with background noise present. Directionality allows for the hearing aid wearer to better understand speech sounds through the use of directional microphones in the device. Our directional
microphone technology helps the hearing aid wearer focus on sounds originating from the front by de-emphasizing noise sounds originating from all other directions. Innova significantly improves on our noise reduction algorithms and has superior
directionality capabilities. In addition, our new platform technology provides us the opportunity to develop a broad product line of full-featured hearing aids that can allow us to compete effectively at more price points of the hearing aid market.



We are competing in an industry that includes six larger competitors who have
significant marketing and distribution capabilities. This makes it difficult for us to compete using the traditional distribution channel. For this reason, we are interested in non-traditional distribution methods. We believe we are making progress
with this strategy in several countries. In Germany, we sell direct to the consumer and use the ENT doctor to perform the hearing aid fitting. In Australia and Switzerland, we sell direct to the consumer through retail stores. In Austria, our
largest customer is a chain of electronics stores that also sells hearing aids. In the Netherlands, our largest customer is a chain of optical stores that also sell hearing aids. In the U.S., as a result of our purchase of Tympany in December 2004,
we plan to use the Primary Care Physician (PCP) to screen patients for hearing loss. Tympanys Otogram allows the PCP to test patients for hearing loss with little disruption to the normal office routine. If the patient has a
hearing loss, the PCP can refer the patient to a hearing aid retailer. Retailers typically complain that the most difficult part of running a successful hearing aid retail business is getting enough patients into the office at a reasonable cost. We
hope to solve the retailers chief complaint  lack of patients  with this non-traditional approach.



Financial Results



As we anticipated, the introduction of our Innova product family in late March resulted in significantly increasing sales and allowed us to return to
profitability in the second quarter 2005 from a substantial loss in the first quarter 2005. We expect to be profitable in the second half of the year; however, Tympany will continue to be dilutive for the balance of 2005 as we execute our strategy
of placing Otograms with the PCP on a per-procedure fee basis.



RESULTS OF
OPERATIONS



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



|                                            |  |                                |   |  |                              |   |  |       |    |  |       |  
|------------------------------------------- |  | ------------------------------ | - |  | ---------------------------- | - |  | ----- | -- |  | ----- | -
|                                            |  | For three months endedJune 30, |   |  | For six months endedJune 30, |  
|                                            |  | 2005                           |   |  | 2004                         |   |  | 2005  |    |  | 2004  |  
|Net sales                                   |  | 100.0                          | % |  | 100.0                        | % |  | 100.0 | %  |  | 100.0 | %
|Cost of sales                               |  | 44.5                           |   |  | 43.8                         |   |  | 45.4  |    |  | 44.2  |  
|                                            |  |                                |   |  |                              |   |  |       |    |  |       |  
|Gross profit                                |  | 55.5                           |   |  | 56.2                         |   |  | 54.6  |    |  | 55.8  |  
|Selling, general and administrative expense |  | 48.5                           |   |  | 43.4                         |   |  | 52.6  |    |  | 40.7  |  
|Research and development expense            |  | 7.1                            |   |  | 9.6                          |   |  | 8.0   |    |  | 9.7   |  
|                                            |  |                                |   |  |                              |   |  |       |    |  |       |  
|Operating profit (loss)                     |  | (0.1                           | ) |  | 3.2                          |   |  | (6.0  | )  |  | 5.4   |  
|Other income (expense), net                 |  | 0.4                            |   |  | (0.2                         | ) |  | 0.2   |    |  | (0.1  | )
|                                            |  |                                |   |  |                              |   |  |       |    |  |       |  
|Income (loss) before income taxes           |  | 0.3                            |   |  | 3.0                          |   |  | (5.8  | )  |  | 5.3   |  
|Provision (benefit) for income taxes        |  | (0.6                           | ) |  | 0.4                          |   |  | (0.1  | )  |  | 0.9   |  
|                                            |  |                                |   |  |                              |   |  |       |    |  |       |  
|Net income (loss)                           |  | 0.9                            | % |  | 2.6                          | % |  | (5.7  | )% |  | 4.4   | %
|                                            |  |                                |   |  |                              |   |  |       |    |  |       |  



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 segment were as follows:



|              |  |                             |        |      |                           |        |  |    |      |  |      |        |        |   |        |  |    |  
|------------- |  | --------------------------- | ------ | ---- | ------------------------- | ------ |  | -- | ---- |  | ---- | ------ | ------ | - | ------ |  | -- | -
|              |  | Three months ended June 30, |        |      | Six months ended June 30, |       
|              |  | 2005                        |        | 2004 |                           | Change |  |    | 2005 |  | 2004 |        | Change |  
|North America |  | $                           | 13,255 |      | $                         | 9,626  |  | 38 | %    |  | $    | 22,849 |        | $ | 19,231 |  | 19 | %
|Europe        |  |                             | 11,926 |      |                           | 10,513 |  | 13 |      |  |      | 24,204 |        |   | 23,097 |  | 5  |  
|Rest-of-world |  |                             | 5,004  |      |                           | 4,199  |  | 19 |      |  |      | 9,023  |        |   | 8,316  |  | 9  |  
|              |  |                             |        |      |                           |        |  |    |      |  |      |        |        |   |        |  |    |  
|Total         |  | $                           | 30,185 |      | $                         | 24,338 |  | 24 | %    |  | $    | 56,076 |        | $ | 50,644 |  | 11 | %
|              |  |                             |        |      |                           |        |  |    |      |  |      |        |        |   |        |  |    |  



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Net sales in the second quarter 2005 were a record $30,185, an increase of 24% from second quarter 2004 net sales of
$24,338. Net sales in the first half 2005 were $56,076, an increase of 11% from first half 2004 net sales of $50,644. The increase was almost completely the result of the introduction of our next-generation Innova product family in the U.S. market
in late March 2005 and the effect of Tympany, which was acquired in December 2004.



North American sales for the first half 2005 of $22,849 were up $3,618, or 19%, from first half 2004 sales of $19,231. North American sales in the second quarter 2005 were up $3,629, or 38%, from last years second quarter sales of
$9,626. First and second quarter 2005 sales included sales from Tympany. Second quarter 2005 U.S. hearing aid sales increased 18% from last years second quarter sales level and second quarter 2005 Canadian sales increased by 52% over last
years second quarter sales level principally as a result of the Innova introduction. Tympany sales were affected by the recognition of deferred revenue pertaining to an upgrade obligation that existed at the acquisition date, which added $756
in the second quarter 2005 and $2,065 in the first half 2005 of very low-margin revenue. This revenue will not recur as the upgrades have been largely completed. As we have previously indicated, we are investing in our future with Tympany as it is
currently generating significant losses. We expect North American sales to decrease in the third quarter due to vacation schedules and the elimination of Tympany deferred revenue related to the upgrade obligation, but to increase in the fourth
quarter as new products are introduced.



European sales of $11,926 in the
second quarter were up $1,413, or 13%, from second quarter 2004 sales of $10,513 as each of our six European subsidiaries experienced increased sales. European sales of $24,204 for the first half 2005 were up $1,107, or 5%, from first half 2004
sales of $23,097. The rebound in German order activity, which started in September 2004, continued. We expect European sales to decrease in the third quarter as a result of the European vacation schedule; however, we expect European sales to
increase when Innova is introduced into non-English speaking markets in the fourth quarter.



Rest-of-world sales of $5,004 in the second quarter 2005 were up 19% from second quarter 2004 sales of $4,199. Rest-of-world sales of $9,023 in first half 2005 were up 9% from the first half 2004 sales of $8,316. The
increases were mainly due to the May 2005 introduction of Innova into the Australian market. We expect rest-of-world sales to increase in the second half of 2005 as Australia benefits from the Innova technology and Innova-related marketing
initiatives.



We believe it is important to have a number of product families
to provide our customers with pricing flexibility in selling to the hearing impaired consumer. We now have six product families  Innova, Natura 3, Natura 2SE, Altair, Tribute and Quartet. Consumers have continued to seek out lower-priced
digital hearing aids, which in combination with competitive pricing has put pressure on our overall average selling price and gross margin. However, with the introduction of Innova, our overall average selling price increased in the second quarter
2005.



We generally have a 60-day return policy for our hearing aids.
Provisions for sales returns were $5,355 and $2,888 in the second quarter 2005 and 2004, respectively and $8,130 and $6,039 for the six months ended June 30, 2005 and 2004, respectively. Actual sales returns were $4,325 and $3,225 in the second
quarter 2005 and 2004, respectively and $7,057 and $6,712 for the six months ended June 30, 2005 and 2004, respectively. The increases were due to the significantly greater sales in 2005. In addition, in the second quarter 2005 (i) we had a higher
percentage of sales in the U.S. where return rates are considerably higher than outside the U.S. and (ii) we had a higher percentage of high-priced Innova product sales as a percentage of total sales. Generally, in the hearing aid business, the
higher the price of the hearing aid, the greater the rate at which it is returned. 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). Our gross profit and gross margin by reportable segment were as follows:



|              |  |                             |        |  |                           |   |  |      |        |  |      |   |  |   |        |  |      |   |  |   |        |  |      |  
|------------- |  | --------------------------- | ------ |  | ------------------------- | - |  | ---- | ------ |  | ---- | - |  | - | ------ |  | ---- | - |  | - | ------ |  | ---- | -
|              |  | Three months ended June 30, |        |  | Six months ended June 30, |  
|              |  | 2005                        |        |  | 2004                      |   |  | 2005 |        |  | 2004 |  
|North America |  | $                           | 6,910  |  | 52.1                      | % |  | $    | 5,705  |  | 59.3 | % |  | $ | 11,876 |  | 52.0 | % |  | $ | 11,175 |  | 58.1 | %
|Europe        |  |                             | 6,438  |  | 54.0                      |   |  |      | 5,117  |  | 48.7 |   |  |   | 12,655 |  | 52.3 |   |  |   | 11,544 |  | 50.0 |  
|Rest-of-world |  |                             | 3,418  |  | 68.4                      |   |  |      | 2,853  |  | 67.9 |   |  |   | 6,092  |  | 67.5 |   |  |   | 5,533  |  | 66.5 |  
|              |  |                             |        |  |                           |   |  |      |        |  |      |   |  |   |        |  |      |   |  |   |        |  |      |  
|Total         |  | $                           | 16,766 |  | 55.5                      | % |  | $    | 13,675 |  | 56.2 | % |  | $ | 30,623 |  | 54.6 | % |  | $ | 28,252 |  | 55.8 | %
|              |  |                             |        |  |                           |   |  |      |        |  |      |   |  |   |        |  |      |   |  |   |        |  |      |  



Gross profit in the second quarter
2005 of $16,766 established a quarterly record and was up 23% from last years second quarter level of $13,675. Second quarter 2005 gross margin of 55.5% was down slightly from 56.2% in last years second



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quarter. Gross profit in the first half 2005 of $30,623 was up 8% from last years first half level of $28,252. First half 2005 gross margin of 54.6%
was down from 55.8% in last years first half. The decreased gross margin in 2005 resulted primarily from the low-margin Tympany deferred revenue. Excluding Tympany, second quarter 2005 gross margin would have been 57.2% and first half 2005
gross margin would have been 56.4%, which principally results from higher average selling prices commanded by the Innova product family. Innova, as a premium-performing/premium-priced product, has improved our overall average selling price and also
increased our unit sales allowing us to achieve better overhead absorption as a result of the additional unit volume. This, in combination with reduced purchased component and assembly costs, lower sales return rates and the elimination of
low-margin Tympany deferred revenue should result in gross margin continuing to expand through the balance of 2005.



Provisions for warranty increased from $1,001 in the second quarter 2004 to $1,679 in the second quarter 2005 and from $1,990 for the six months ended June 30, 2004 to
$2,673 for the six months ended June 30, 2005. Actual warranty expenditures were $1,287 and $1,014 in the second quarter 2005 and 2004, respectively. Actual warranty expenditures were $2,507 and $2,046 for the six months ended June 30, 2005 and
2004, respectively. The provisions as compared with actual warranty expenditures are higher due to increased sales and an increase in the length of the warranty period offered on our high-end product lines. We now offer a standard three-year
warranty in the U.S. for high-end products.



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 expenses.



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



|              |  |                             |        |  |                           |   |  |      |        |  |      |   |  |   |        |  |      |   |  |   |        |  |      |  
|------------- |  | --------------------------- | ------ |  | ------------------------- | - |  | ---- | ------ |  | ---- | - |  | - | ------ |  | ---- | - |  | - | ------ |  | ---- | -
|              |  | Three months ended June 30, |        |  | Six months ended June 30, |  
|              |  | 2005                        |        |  | 2004                      |   |  | 2005 |        |  | 2004 |  
|North America |  | $                           | 7,207  |  | 54.4                      | % |  | $    | 4,583  |  | 47.6 | % |  | $ | 15,230 |  | 66.7 | % |  | $ | 9,103  |  | 47.3 | %
|Europe        |  |                             | 4,509  |  | 37.8                      |   |  |      | 3,652  |  | 34.7 |   |  |   | 8,616  |  | 35.6 |   |  |   | 7,024  |  | 30.4 |  
|Rest-of-world |  |                             | 2,944  |  | 58.8                      |   |  |      | 2,327  |  | 55.4 |   |  |   | 5,668  |  | 62.8 |   |  |   | 4,479  |  | 53.9 |  
|              |  |                             |        |  |                           |   |  |      |        |  |      |   |  |   |        |  |      |   |  |   |        |  |      |  
|Total         |  | $                           | 14,660 |  | 48.6                      | % |  | $    | 10,562 |  | 43.4 | % |  | $ | 29,514 |  | 52.6 | % |  | $ | 20,606 |  | 40.7 | %
|              |  |                             |        |  |                           |   |  |      |        |  |      |   |  |   |        |  |      |   |  |   |        |  |      |  



Selling, general and administrative
expense in the second quarter 2005 of $14,660 was up $4,098, or 38.7%, from last years second quarter level of $10,562. Selling, general and administrative expense in the first half 2005 of $29,514 was up $8,908, or 43.2%, from last
years first half level of $20,606. This was principally as a result of our December 2004 acquisition of Tympany, significant training and marketing costs connected with Innova, and increased selling and marketing costs in Australia and
Germany. As a percentage of sales, selling, general and administrative expense increased from 43.4% in the second quarter 2004 to 48.6% in the second quarter 2005 and from 40.7% in the first half 2004 to 52.6 % in the second quarter 2005. Excluding
Tympany, second quarter 2005 selling, general and administrative expense as a percentage of sales would have been 46.0% and the first half 2005 selling, general and administrative expense would have been 50.0%. We expect selling, general and
administrative expense to remain consistent with the second quarter 2005 level for the balance of 2005.



Research and Development. Research and development expense primarily consists of wages and benefits for research, development, engineering, regulatory and clinical personnel, and also includes consulting,
intellectual property, clinical study and engineering support costs. Research and development expense in the second quarter 2005 of $2,136 decreased by $210, or 9%, from last years second quarter level of $2,346. Research and development
expense in the first half 2005 of $4,488 decreased by $412, or 8%, from last years first half level of $4,900. This decrease occurred despite research and development expenses associated with Tympany, mainly as a result of the timing of
expenses relating to our development of the next generation integrated circuitry in the Innova product family. As a percentage of sales, research and development expense went from 9.6% in the second quarter 2004 to 7.1% in the second quarter 2005
and from 9.7% in the first half 2004 to 8.0% in the first half 2005. We expect research and development expense to remain consistent with the second quarter 2005 level in the near term but will begin to increase in 2006.



Other Income/Expense. Other income/expense primarily consists of foreign currency
gains and losses and interest income and interest expense. Other income was $128 in the second quarter 2005 compared to other expense of $29 in the second quarter 2004. Other income was $88 in the first half 2005 compared to other expense of $78 in
the first half 2004. Other income/expense is not expected to be a significant item for us for the balance of 2005.



Provision/Benefit for Income Taxes. We had an income tax benefit in the second quarter 2005 of $165 compared to an income tax provision of $114 in the second
quarter 2004. We had an income tax benefit in the first half 2005 of $77



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compared to an income tax provision of $456 in the first half 2004. The provisions/benefits related primarily to pre-tax earnings or losses in certain
countries outside the U.S. Income taxes on U.S. profits have been substantially negated by our net operating loss carry-forward. Our effective tax rate going forward will depend on our mix of profitability between countries.



LIQUIDITY AND CAPITAL RESOURCES



Net cash used in operating activities was $9,074 for the six months ended June 30, 2005.
Negative cash flow resulted from the net loss of $3,214, as positively affected by certain non-cash expenses including depreciation and amortization of $2,767, stock-based compensation of $159 and foreign currency losses of $498. In addition, cash
was used to increase (i) accounts receivable by $3,617 principally as a result of increased sales; (ii) inventory by $3,105 principally as a result of the build of Innova hearing aids and Tympany Otogram machines; (iii) prepaid expenses and other by
$234; and (iv) other assets by $226. Cash was also used to decrease accounts payable and accrued expenses by $2,102. We assumed significant Tympany accounts payable upon its acquisition in December 2004 and paid them off in the first half 2005.



Net cash provided by investing activities of $4,422 for the six months ended
June 30, 2005 resulted from net repayments of customer advances of $348 and net proceeds from the maturity of marketable securities of $6,851, partially offset by cash paid related to acquisitions of businesses and intangibles of $1,047 and
purchases of property and equipment of $1,730.



Net cash provided by financing
activities of $3,632 for the six months ended June 30, 2005 resulted from proceeds from the collection of $2,979 of certain accounts receivable that were deemed uncollectible prior to the acquisition of Sanomed and which are payable to the former
owners, proceeds from stock option exercises and employee stock purchases of $484, proceeds from borrowings on a line of credit of $639 and a decrease in restricted cash, cash equivalents and marketable securities of $174. These positive cash flow
items were partially offset by loan principal payments of $644. Borrowings under our line of credit must be entirely secured by cash and investments.



Our cash and marketable securities, including restricted amounts, totaled $23,725 as of June 30, 2005. We have a number of items that will negatively affect our cash
balance through the balance of 2005. The more significant items to be paid from available cash follow:



| |  |  | We will pay $3,815 to the former owners of Sanomed for amounts collected on accounts receivable that had been deemed uncollectible prior to the acquisition.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | We will make contingent consideration payments in connection with our 2003 acquisition of Sanomed of $1,508 and 2004 acquisition of Tympany of $415.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | We will be purchasing a number of Otogram machines for $800.
| | - |  | ------------------------------------------------------------



| |  |  | We will make principal payments of $600 on our loan payable.
| | - |  | ------------------------------------------------------------



In addition, we may use cash to fund acquisitions of complementary businesses and technologies. We believe that our cash and marketable securities balance will be
adequate to meet our operating, working capital and investment requirements into 2006.



RECENT ACCOUNTING PRONOUNCEMENTS



In November 2004, the
Financial Accounting Standards Board (FASB) issued SFAS No. 151, Inventory Costsan amendment of ARB No. 43, Chapter 4, which clarifies that abnormal inventory costs such as costs of idle facilities, excess freight and
handling costs and wasted materials (spoilage) are required to be recognized as current period charges. SFAS No. 151 is effective for fiscal years beginning after June 15, 2005. We are currently evaluating the provisions of SFAS No. 151 and do not
believe the adoption will have a material effect on our results of operations and financial position.



In December 2004, the FASB issued SFAS No. 123R, Share-Based Payment, which requires all share-based payments to employees, including grants of employee stock options, to be recognized as an expense. The
value is recognized over the requisite service period based on fair values measured on grant dates. The new standard may be adopted using either the modified prospective method or the modified retrospective method. In March 2005, the Securities and
Exchange Commission (SEC) issued Staff Accounting Bulletin (SAB) No. 107, Share-Based Payment, which clarified the SECs expectations with regard to the assumptions underlying the fair value estimates of
options. In April 2005, the SEC amended the compliance dates for SFAS No. 123R such that the new standard will be effective for us beginning January 1, 2006. We are currently evaluating our share-based employee compensation programs, the potential
effect of these statements on our results of operations and financial position and the alternative adoption methods.



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In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections, which replaces APB
Opinion No. 20, Accounting Changes, and SFAS No. 3, Reporting Accounting Changes in Interim Financial Statements, and requires that a voluntary change in accounting principle be applied retrospectively to all prior period
financial statements presented, unless it is impracticable to do so. SFAS No. 154 also provides that a change in method of depreciating or amortizing a long-lived non-financial asset be accounted for as a change in estimate effected by a change in
accounting principle, and also provides that correction of errors in previously issued financial statements should be termed a restatement. SFAS No. 154 is effective for fiscal years beginning December 15, 2005. We do not believe the
adoption of SFAS No. 154 will have a material impact on our results of operations and financial position.



FACTORS THAT MAY AFFECT FUTURE PERFORMANCE



Our future results, plans, objectives, expectations and intentions could be affected by any of the following risk factors. Investors should understand that it is not possible to predict or identify all such factors, and we are
under no obligation to update these factors. Investors should not consider the factors listed as a complete statement of all potential risks and uncertainties.



We have a history of losses.



We have a history of losses and a significant accumulated deficit and have not yet become consistently profitable. We may incur net losses in the future. Whether or not
we achieve consistent profitability or increase profitability will depend in significant part on increasing our net sales, maintaining or improving our gross margin and maintaining or limiting increases in our operating expenses. Consequently, it is
possible that we will not achieve consistent profitability or increase profitability on a quarterly or annual basis in the future.



We face aggressive competition in our business, and if we do not compete effectively our net sales and operating results will suffer.



We encounter aggressive competition from a number of competitors worldwide, six of which
have far greater sales and more extensive financial and business resources than we have. We may not choose to, or be able to, match the type or the volume of incentives that our competitors provide to hearing aid retailers, which could put us at a
competitive disadvantage. In addition, some competitors have purchased or established their own network of owned or franchised retail hearing aid operations or are adding to those networks, all of which could cause us to lose existing customers and
make it difficult to recruit new customers. If any of our competitors were to merge with one another, it could make it significantly more difficult for us to compete. If we fail to compete effectively, our net sales and operating results will
suffer.



Our financial results may fluctuate significantly, which may cause
our stock price to decline.



Our quarterly and annual operating results
have fluctuated significantly in the past and may fluctuate significantly in the future. These fluctuations could cause our stock price to vary significantly or decline. Factors that may cause fluctuations in our operating results include the
following: general economic conditions; hearing aid market conditions; the competitive performance of our products; delays or problems completing or introducing new products; expenses associated with trying innovative distribution methods;
difficulties in integrating and managing acquired operations that could result in poor performance, additional expenses or write downs of acquired intangible assets; changes in government healthcare systems and reductions in reimbursement levels for
hearing aids or diagnostic hearing testing; distribution of our products; competitive pressures resulting in lower selling prices or significant promotional costs; difficulties in relationships with our customers; demand for and market acceptance of
our products, particularly new products where eventual market acceptance may not follow early indications; reductions in orders from larger customers; high levels of returns, remakes and repairs; changes in our product or customer mix; regulatory
requirements; difficulties in managing international operations; the effect of future acquisitions, if any; the effect of international conflicts and threats; inability to forecast revenue accurately; nonpayment of receivables; the announcement or
introduction of new products or services by our competitors; manufacturing problems; component availability and pricing; and other business factors beyond our control.



If net sales for a particular period were below our expectations, it is highly unlikely that we could proportionately reduce our operating
expenses for that period. Therefore, any revenue shortfall would have a disproportionately negative effect on our operating results for the period. You should not rely on our results for any one quarter as an indication of our future performance. In
future quarters, our operating results may be below the expectations of public market analysts or investors. If this occurs, our stock price would very likely decrease.



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We have made a number of acquisitions and could make additional acquisitions, which could be difficult to integrate,
disrupt our business, dilute the equity of our shareholders and harm our operating results.



We may not be able to meet performance expectations for, or successfully integrate, businesses we have acquired or may acquire on a timely basis or at all. For example, it is too soon to evaluate whether Tympany,
Inc., which was acquired in December 2004 and which is currently generating significant losses, will achieve our expectations and positively affect our overall business.



As part of our business strategy, we may continue to make acquisitions that complement or expand our existing business. Acquisitions involve
risks, including (i) the inability to successfully integrate acquired businesses or to realize anticipated synergies, economies of scale or other expected value; (ii) difficulties in managing and coordinating operations at new sites; (iii) the loss
or termination of key employees of acquired businesses; (iv) the loss of key customers of acquired businesses; (v) diversion of managements attention from other business concerns; and (vi) risks of entering businesses and markets in which we
have no direct or limited prior experience. Acquisitions may result in the utilization of cash and marketable securities, dilutive issuances of equity securities and the incurrence of debt, any of which would weaken our financial position. In
addition, acquisitions would result in the creation of (i) certain definite-lived intangible assets that increase amortization expense and (ii) goodwill and other indefinite-lived intangible assets that subsequently may result in large write-offs
should these assets become impaired.



Our internal control over financial
reporting may not be considered effective, resulting in possible regulatory sanctions.



Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, we are required to furnish an annual report on our internal control over financial reporting. This report contains an assessment by our management of the
effectiveness of our system of internal control over financial reporting (including the disclosure of any material control weaknesses) and a statement that our auditors have attested to and reported on managements evaluation of such system of
internal control. While we strive to maintain an effective system of internal control, if we or our auditors were unable to attest to the effectiveness of our system of internal control, we would not be able to comply with the Sarbanes-Oxley Act of
2002, and our business and our stock price could be adversely affected.



The
loss of any large customer or a reduction in orders from any large customer could reduce our net sales and harm our operating results.



We anticipate that our operating results in any given period will depend in part upon revenues from a number of larger customers. Our customers are not generally
contractually obligated to purchase any fixed quantities of products, and they may stop placing orders with us at any time. We may be unable to retain our current customers, and we may be unable to recruit replacement or additional customers. We are
selling hearing aids to a number of retail chains that have a large number of owned or franchised locations. We are subject to the risk of losing our larger customers, incurring significant reductions in sales to these customers, reducing future
prices in response to demands from these customers or incurring substantial marketing expenses in order to maintain their business. In addition, we are subject to the risk of being unable to collect receivable balances from these customers.



We rely on several suppliers and contractors, and our business will be
seriously harmed if these suppliers and contractors are not able to meet our requirements.



Certain critical components used in our products are currently available only from a single or limited number of suppliers. For example, our proprietary digital signal processing chips are manufactured by a single
supplier. These suppliers may not be willing or able to satisfy our requirements. We also rely on a limited number of contractors for certain hearing aid component assembly, Otogram assembly and advanced integrated circuitry development and are
therefore subject to their performance, over which we have little control. We may lose the services of these key suppliers or contractors. Finding a substitute part, process, supplier or contractor may be expensive and time-consuming, or may prove
impossible in the near-term.



We have high levels of product returns,
remakes and repairs, and our net sales and operating results will be lower if these levels increase.



We generally offer a minimum 60-day return policy and various warranties on our hearing aids. In general, the hearing aid industry has high levels of returns, remakes and repairs, and our level of returns, remakes and
repairs has been significant. We may not be able to attain lower levels of returns, remakes and repairs and, in fact, these levels may increase, particularly on newly introduced products, which could reduce our net sales and operating results.



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IF we fail to develop new and innovative products, our competitive position will suffer, and if our new products are
not well accepted, our net sales and operating results will suffer.



In
order to be successful, we must develop new products and be a leader in the commercialization of new technology innovations in the hearing aid market. Technological innovation is expensive and unpredictable and among other things, requires hiring
(i) expert personnel who are difficult to find and attract, or (ii) external contractors to perform complex tasks. Without the timely introduction of new products, our existing products are likely to become technologically obsolete over time, which
would harm our business. We may not have the technical capabilities necessary to develop further technologically innovative products. In addition, any enhancements to, or new generations of, our products, even if successfully developed, may not
generate significant revenues. Our products may be rendered obsolete by changing consumer preferences or the introduction of products embodying new technologies or features by us or our competitors. Obsolescence of our products, a
breakthrough new method of addressing hearing loss or the introduction of technologically superior products by new or existing competitors could cause us a rapid loss of sales or market share, which would have a significant adverse
effect on our net sales, operating results and stock price.



Because of the
complexity of our products, there may be undiscovered errors or defects that could harm our business or reputation.



Our products are complex and may contain undetected defects, errors or failures. Our customers may discover errors after new products have been introduced and sold. The
occurrence of any defects, errors or failures could result in the loss of or delay in market acceptance of our new products, which could harm our reputation and business and adversely affect our net sales and operating results.



Third parties have claimed and may claim in the future that we are infringing their
intellectual property, and we could suffer significant expense or be prevented from selling products if these claims are successful.



Third parties have claimed and may claim in the future that we are infringing their intellectual property rights. While we do not believe that any of our products
currently infringe the proprietary rights of others, we may be unaware of intellectual property rights of others that may cover some of our technology. Whether or not we actually infringe a third partys rights, any litigation regarding
intellectual property could be costly and time-consuming and divert our management and key personnel from our business operations. Claims of intellectual property infringement might also require us to make one-time payments or enter into costly
royalty or license agreements.



Because our success depends on our
proprietary technology, if third parties infringe our intellectual property, we may be forced to expend significant resources enforcing our rights or suffer competitive injury.



Our success depends in large part on our proprietary technology. We rely on a combination of patents, copyrights, trademarks, trade secrets,
confidentiality procedures and licensing arrangements to establish and protect our proprietary technology. These laws, procedures and provisions provide only limited protection. Additionally, some foreign laws do not protect our proprietary rights
to the same extent as U.S. laws. If we fail to successfully enforce our intellectual property rights, our competitive position will suffer, and litigation to enforce these rights would be expensive and may prove ineffective.



Selling through non-traditional distribution channels or in non-traditional ways could
harm our relationships with existing customers and cause them to purchase fewer of our products, which would reduce our net sales and operating results.



In several countries, we sell hearing aids directly to the hearing impaired consumer, and in some markets we are selling our products through non-traditional distribution
channels, such as high-volume general retail and electronics retail stores and the ear-nose-throat physician. Our current initiatives or any future initiatives directed toward alternate distribution could alienate our traditional hearing aid
dispenser customers. For example, our Hearing Health Network could cause hearing aid dispensers that do not qualify or otherwise choose not to participate in this program to reduce or discontinue their purchases from us. Any loss of traditional
revenue may not be offset by revenue from alternative distribution channels, and we may choose not to continue using any of these alternative channels. Should hearing aid dispensers react unfavorably to such initiatives, they would likely purchase
fewer of our products, which would reduce our net sales and operating results and damage our competitive position.



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We are dependent on international operations, which exposes us to a variety of risks that could result in lower sales
and operating results.



International sales, particularly in Germany and
Australia, account for a material portion of our net sales. Our reliance on international operations exposes us to related risks and uncertainties, which, if realized, could cause our sales and operating results to decrease. There is significant
government or public hearing aid reimbursement in a number of countries outside the U.S., which if reduced or eliminated would likely have a negative effect on our sales. For example, reimbursement levels are trending downward in Germany, which has
negatively affected our sales in that country. Other changes in the healthcare systems of countries outside the U.S., such as instituting co-payments or co-insurance, would likely have negative effects on our sales. In order to market our products
in the European Union (EU), we are required to have the EUs CE Mark certification. Any failure to maintain our CE Mark certification would significantly reduce our net sales and operating results. 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 intercompany account balances between our U.S. parent company and our non-U.S. subsidiary companies. Fluctuations in the exchange rates between
the U.S. dollar and other currencies could negatively affect the sales price of our products in international markets or lead to currency exchange losses. In general, our net sales and operating results benefit from a weakening U.S. dollar. If the
U.S. dollar were to strengthen materially from current levels, our net sales and operating results would suffer.



Accounting for stock-based compensation will negatively affect our results.



New accounting rules will require us to expense the value of stock options beginning January 1, 2006. This will result in lower reported
earnings per share as compared to current accounting practice and may lead us to seek alternative means of providing incentive compensation, which could be less effective at attracting, retaining and motivating key employees or have other negative
consequences.



Complications may result from hearing aid use, and we may
incur significant expense if we are sued for product liability.



Although
we have not experienced any significant product liability issues to date, we may be held liable if any product we develop causes injury or is found otherwise unsuitable. If we are sued for an injury caused by our products, the resulting liability
could result in significant expense beyond our products liability insurance limits, which would harm our operating results.



If we fail to comply with food and drug administration regulations or various sales-related laws, we may suffer fines, injunctions or other penalties.



Our products are subject to regulation in the U.S. by the Food and Drug Administration
(FDA) and similar entities in other countries. We must comply with facility registration and product listing requirements of the FDA and similar entities and adhere to the FDAs Quality System Regulations. Noncompliance with applicable FDA and
similar entities requirements can result in fines, injunctions, civil penalties, recall or seizure of products, total or partial suspension of production or criminal prosecution. We must also maintain compliance with federal, state and foreign
laws regarding sales incentives, techniques, referrals and other programs, some of which are unclear or may be read broadly enough to prohibit standard sales programs such as discounts, free training or frequent buyer awards. While we
intend to comply with the law in each of these jurisdictions, if our practices, or those of a competitor, were to attract unfavorable press or governmental attention, our sales could be adversely affected or we could be subject to fines or
governmental injunctions. Any such action would have an adverse effect on our net sales or operating results.



There may be sales of our stock by our directors and officers, and these sales could cause our stock price to fall.



Sales of our stock by our directors and officers, or the perception that such sales will occur, could adversely affect the market price of our stock. Some of our officers
have adopted trading plans under SEC Rule 10b5-1 in order to dispose of a portion of their stock in an orderly manner. Other officers or directors may adopt such a trading plan in the future.



Provisions in our charter documents, our shareholders rights plan and delaware law may
deter takeover efforts that shareholders feel would be beneficial to shareholder value.



Our certificate of incorporation and bylaws, shareholder rights plan and Delaware law contain provisions that could make it harder for a third party to acquire us without the consent of our board of directors. While
we believe these provisions provide for an opportunity to receive a higher bid by requiring potential acquirers to negotiate with our board of directors, these



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provisions apply even if the offer may be considered beneficial by some shareholders, and a takeover bid otherwise favored by a majority of our shareholders
might be rejected by our board of directors.



|ITEM 3. | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS (Amounts in thousands)
|------- | ----------------------------------------------------------------------------------



Interest Rate Risk. We generally invest our cash in money market funds and investment grade corporate debt securities, which we
believe are subject to minimal credit and market risk considering that they are relatively short-term (expected maturities of 18 months or less from date of purchase) and provided that we hold them to maturity, which is our intention.



Derivative Instruments. We enter into readily marketable forward contracts with
financial institutions to minimize the short-term impact of foreign currency fluctuations on certain intercompany balances. We do not enter into these contracts for trading or speculation purposes. Gains and losses on the contracts are included in
net income and offset foreign exchange gains or losses recognized on the revaluation of certain intercompany balances. Our foreign exchange forward contracts generally mature three months from the contract date. On June 30, 2005, we entered into
forward contracts for $1,147 (1,400 Canadian dollars), $3,440 (2,830 Euro), $957 (530 British pounds sterling) and $4,533 (6,000 Australian dollars), all of which expire on September 30, 2005.



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. In the second quarter 2005, approximately 61% of our net sales and
47% of our operating expenses were denominated in currencies other than the U.S. dollar. In the six months ended June 30, 2005, approximately 63% of our net sales and 45% of our operating expenses were denominated in currencies other than the U.S.
dollar. Inventory purchases were transacted primarily 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 Euro and Australian dollar 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. 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.



For the six months ended June 30, 2005 and 2004, average currency exchange rates to convert one U.S. dollar into each local currency for which we had sales of over $3,000 for the six months ended June 30, 2005 and 2004, respectively were as
follows:



|                  |  |      |  |     
|----------------- |  | ---- |  | ----
|                  |  | 2005 |  | 2004
|Euro              |  | 0.78 |  | 0.83
|Australian dollar |  | 1.29 |  | 1.40



|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 to provide reasonable assurance that information required to be included in our Exchange Act reports is properly recorded, processed, summarized and reported within the time periods specified.



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.



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PART II - OTHER INFORMATION



|ITEM 4. | SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
|------- | ---------------------------------------------------



The Companys annual meeting of stockholders was held on May 5, 2005. Directors elected at the meeting and voting were as follows:



|                  |  |            |  |         
|----------------- |  | ---------- |  | --------
|Director          |  | For        |  | Withheld
|James M. Callahan |  | 20,783,918 |  | 19,513  
|Lewis S. Edelheit |  | 20,781,473 |  | 21,958  



Other directors whose
terms of office continued after the meeting were: Andrew G. Raguskus, Kevin J. Ryan, Lawrence C. Ward and Samuel L. Westover.



The result of the voting for the other item of business at the annual meeting was as follows:



|                                                                    |  |            |  |         |  |        
|------------------------------------------------------------------- |  | ---------- |  | ------- |  | -------
|                                                                    |  | For        |  | Against |  | Abstain
|Ratification of the appointment of KPMG LLP as independent auditors |  | 20,677,191 |  | 124,870 |  | 1,370  



|ITEM 6. | EXHIBITS
|------- | --------



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



|          |  |                                                                                  
|--------- |  | ---------------------------------------------------------------------------------
|Exhibit # |  | Description                                                                      
|31.1      |  | Rule 13a-14(a) / 15-d-14(a) Certification of Chief Executive Officer             
|          | 
|31.2      |  | Rule 13a-14(a) / 15-d-14(a) Certification of Chief Financial Officer             
|          | 
|32        |  | Section 1350 Certification of Chief Executive Officer and Chief Financial Officer



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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: August 9, 2005



/s/STEPHEN L. WILSONStephen L. WilsonSenior Vice President and Chief FinancialOfficer and Secretary




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