UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C. 20549





FORM 10-Q




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




FOR
THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2010




or




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




Commission
File No. 000-30335





OTIX
GLOBAL, INC.


(Exact
name of registrant as specified in its charter)





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





4246
South Riverboat Road, Suite 300


Salt
Lake City, UT 84123


(Address
of principal executive offices)




(801)
312-1700


(Registrant’s
telephone number, including area code)







Indicate
by check mark whether the registrant: (1) has filed all reports required to
be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. x Yes  ̈ No




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




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




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




Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act):


 ̈ Yes x No




As of
November 16, 2010, there were 5,599,303 shares of the registrant’s $0.005 par
value common stock outstanding.





OTIX
GLOBAL, INC.


TABLE
OF CONTENTS




PagePART
      I. FINANCIAL INFORMATIONITEM 1.
                                            
                                            Condensed
      Consolidated Financial Statements (Unaudited):Condensed
      Consolidated Balance Sheets as of September 30, 2010 and December 31,
      2009
                                            
                                            3Condensed
      Consolidated Statements of Operations for the Three and Nine Months Ended
      September 30, 2010 and 2009
                                            
                                            4Condensed
      Consolidated Statements of Cash Flows for the Nine Months Ended September
      30, 2010 and 2009
                                            
                                            5Notes
      to Condensed Consolidated Financial Statements
                                            
                                            6ITEM 2.
                                            
                                            Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
                                            
                                            16ITEM 3.
                                            
                                            Quantitative
      and Qualitative Disclosures about Market Risks
                                            
                                            26ITEM 4.
                                            
                                            Controls
      and Procedures
                                            
                                            27PART
      II. OTHER INFORMATIONITEM 1.
                                            
                                            Legal
      Proceedings
                                            
                                            27ITEM 1A.
                                            
                                            Risk
      Factors
                                            
                                            27ITEM
      4.
                                            
                                            Reserved
                                            
                                            28ITEM 6.
                                            
                                            Exhibits
                                            
                                            28SIGNATURE
                                            
                                            30CERTIFICATIONS


2




PART
I. FINANCIAL INFORMATION




ITEM 1.
            CONDENSED CONSOLIDATED FINANCIAL
      STATEMENTS (UNAUDITED)




OTIX
GLOBAL, INC.




CONDENSED
CONSOLIDATED BALANCE SHEETS


(in
thousands, except per share data)


(unaudited)


September 30,
                  
                  
                  December 31,2010
                  
                  
                  2009ASSETSCurrent
      assets:Cash
      and cash equivalents
                  
                  $
                  8,409
                  
                  
                  $
                  12,154Restricted
      cash
                  
                  
                  113
                  
                  
                  
                  71Accounts
      receivable, net of allowance for doubtful accounts of $685 and
      $851
                  
                  
                  9,173
                  
                  
                  
                  10,625Inventories
                  
                  
                  7,928
                  
                  
                  
                  8,754Prepaid
      expenses and other
                  
                  
                  3,484
                  
                  
                  
                  4,315Total
      current assets
                  
                  
                  29,107
                  
                  
                  
                  35,919Property
      and equipment, net of accumulated depreciation and amortization of $22,472
      and $19,941
                  
                  
                  9,181
                  
                  
                  
                  8,755Definite-lived
      intangible assets, net
                  
                  
                  2,645
                  
                  
                  
                  3,016Indefinite-lived
      intangible assets
                  
                  
                  10,194
                  
                  
                  
                  9,368Goodwill
                  
                  
                  7,446
                  
                  
                  
                  7,772Other
      assets
                  
                  
                  1,181
                  
                  
                  
                  2,295Total
      assets
                  
                  $
                  59,754
                  
                  
                  $
                  67,125LIABILITIES
      AND SHAREHOLDERS’ EQUITYCurrent
      liabilities:Current
      portion of long-term debt
                  
                  $
                  4,150
                  
                  
                  $
                  4,923Accounts
      payable
                  
                  
                  6,534
                  
                  
                  
                  6,426Accrued
      payroll and related expenses
                  
                  
                  3,931
                  
                  
                  
                  4,515Accrued
      restructuring
                  
                  
                  1,754
                  
                  
                  
                  356Accrued
      warranty
                  
                  
                  3,490
                  
                  
                  
                  3,901Deferred
      revenue
                  
                  
                  5,207
                  
                  
                  
                  4,602Other
      accrued liabilities
                  
                  
                  4,060
                  
                  
                  
                  3,602Total
      current liabilities
                  
                  
                  29,126
                  
                  
                  
                  28,325Long-term
      debt, net of current portion
                  
                  
                  791
                  
                  
                  
                  452Deferred
      revenue, net of current portion
                  
                  
                  3,934
                  
                  
                  
                  5,264Other
      liabilities
                  
                  
                  253
                  
                  
                  
                  282Total
      liabilities
                  
                  
                  34,104
                  
                  
                  
                  34,323Commitments
      and contingencies (Note 4)Shareholders’
      equity:Preferred
      stock, $0.001 par value; 5,000 shares authorized; zero issued and
      outstanding
                  
                  
                  -
                  
                  
                  
                  -Common
      stock; $0.005 par value; 14,000 shares authorized; 5,782 and 5,762 shares
      issued and outstanding, respectively
                  
                  
                  29
                  
                  
                  
                  29Additional
      paid-in-capital
                  
                  
                  146,208
                  
                  
                  
                  145,359Accumulated
      deficit
                  
                  
                  (127,462
                  )
                  
                  
                  (118,244
                  )Accumulated
      other comprehensive income
                  
                  
                  10,648
                  
                  
                  
                  9,431Treasury
      stock; 195 shares at cost
                  
                  
                  (3,773
                  )
                  
                  
                  (3,773
                  )Total
      shareholders’ equity
                  
                  
                  25,650
                  
                  
                  
                  32,802Total
      liabilities and shareholders’ equity
                  
                  $
                  59,754
                  
                  
                  $
                  67,125





See
accompanying notes to condensed consolidated financial
statements.


3


OTIX
GLOBAL, INC.




CONDENSED
CONSOLIDATED STATEMENTS OF OPERATIONS


(in
thousands, except per share data)


(unaudited)





Three months ended
                            September 30,
                          
                          
                          Nine months ended
                            September 30,2010
                          
                          
                          2009
                          
                          
                          2010
                          
                          
                          2009Net
      sales
                          
                          $
                          21,919
                          
                          
                          $
                          23,139
                          
                          
                          $
                          64,322
                          
                          
                          $
                          72,991Cost
      of sales
                          
                          
                          9,139
                          
                          
                          
                          9,069
                          
                          
                          
                          24,833
                          
                          
                          
                          29,294Gross
      profit
                          
                          
                          12,780
                          
                          
                          
                          14,070
                          
                          
                          
                          39,489
                          
                          
                          
                          43,697Selling,
      general and administrative expense
                          
                          
                          14,669
                          
                          
                          
                          14,560
                          
                          
                          
                          44,098
                          
                          
                          
                          44,179Research
      and development expense
                          
                          
                          1,055
                          
                          
                          
                          1,340
                          
                          
                          
                          3,014
                          
                          
                          
                          5,248Goodwill
      and definite-lived intangibles impairment charges
                          
                          
                          -
                          
                          
                          
                          135
                          
                          
                          
                          -
                          
                          
                          
                          14,793Restructuring
      charge
                          
                          
                          1,599
                          
                          
                          
                          98
                          
                          
                          
                          1,579
                          
                          
                          
                          623Operating
      loss
                          
                          
                          (4,543
                          )
                          
                          
                          (2,063
                          )
                          
                          
                          (9,202
                          )
                          
                          
                          (21,146
                          )Interest
      expense
                          
                          
                          (58
                          )
                          
                          
                          (102
                          )
                          
                          
                          (187
                          )
                          
                          
                          (379
                          )Other
      income (expense), net
                          
                          
                          (122
                          )
                          
                          
                          218
                          
                          
                          
                          74
                          
                          
                          
                          303Loss
      before income taxes
                          
                          
                          (4,723
                          )
                          
                          
                          (1,947
                          )
                          
                          
                          (9,315
                          )
                          
                          
                          (21,222
                          )Provision
      (benefit) for income taxes
                          
                          
                          23
                          
                          
                          
                          115
                          
                          
                          
                          (105
                          )
                          
                          
                          390Loss
      from continuing operations
                          
                          
                          (4,746
                          )
                          
                          
                          (2,062
                          )
                          
                          
                          (9,210
                          )
                          
                          
                          (21,612
                          )Loss
      from discontinued operations, net of income taxes
                          
                          
                          (1
                          )
                          
                          
                          (2
                          )
                          
                          
                          (8
                          )
                          
                          
                          (12
                          )Net
      loss
                          
                          $
                          (4,747
                          )
                          
                          $
                          (2,064
                          )
                          
                          $
                          (9,218
                          )
                          
                          $
                          (21,624
                          )Basic
      and diluted loss per common share:Continuing
      operations
                          
                          $
                          (0.85
                          )
                          
                          $
                          (0.37
                          )
                          
                          $
                          (1.65
                          )
                          
                          $
                          (3.91
                          )Discontinued
      operations
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -Net
      loss
                          
                          $
                          (0.85
                          )
                          
                          $
                          (0.37
                          )
                          
                          $
                          (1.65
                          )
                          
                          $
                          (3.91
                          )Weighted
      average number of common shares outstanding:Basic
      and diluted
                          
                          
                          5,585
                          
                          
                          
                          5,541
                          
                          
                          
                          5,578
                          
                          
                          
                          5,530





See
accompanying notes to condensed consolidated financial
statements.


4


OTIX
GLOBAL, INC.




CONDENSED
CONSOLIDATED STATEMENTS OF CASH FLOWS


(in
thousands)


(unaudited)


For the nine months ended
                      September 30,2010
                    
                    
                    2009Cash
      flows from operating activities:Net
      loss
                    
                    $
                    (9,218
                    )
                    
                    $
                    (21,624
                    )Loss
      from discontinued operations, net of income taxes
                    
                    
                    8
                    
                    
                    
                    12Adjustments
      to reconcile net loss to net cash provided by (used in) operating
      activities:Depreciation
      and amortization
                    
                    
                    2,601
                    
                    
                    
                    3,058Stock-based
      compensation
                    
                    
                    854
                    
                    
                    
                    1,098Foreign
      currency loss, net
                    
                    
                    504
                    
                    
                    
                    97Deferred
      income taxes
                    
                    
                    (175
                    )
                    
                    
                    (40
                    )Amortization
      of interest on long-term debt
                    
                    
                    3
                    
                    
                    
                    82Non-cash
      portion of restructuring charge
                    
                    
                    -
                    
                    
                    
                    3Goodwill
      and definite-lived intangible impairment charges
                    
                    
                    -
                    
                    
                    
                    14,793Loss
      on disposal of long-lived assets
                    
                    
                    20
                    
                    
                    
                    -Changes
      in assets and liabilities:Accounts
      receivable
                    
                    
                    1,369
                    
                    
                    
                    4,964Inventories
                    
                    
                    984
                    
                    
                    
                    661Other
      assets
                    
                    
                    397
                    
                    
                    
                    440Withholding
      taxes remitted on share-based awards
                    
                    
                    (20
                    )
                    
                    
                    (38
                    )Accrued
      restructuring
                    
                    
                    1,599
                    
                    
                    
                    (103
                    )Accounts
      payable, accrued expenses and deferred revenue
                    
                    
                    (1,507
                    )
                    
                    
                    (5,150
                    )Net
      cash used in operating activities from continuing
    operations
                    
                    
                    (2,581
                    )
                    
                    
                    (1,747
                    )Net
      cash used in discontinued operations
                    
                    
                    (41
                    )
                    
                    
                    (49
                    )Net
      cash used in operating activities
                    
                    
                    (2,622
                    )
                    
                    
                    (1,796
                    )Cash
      flows from investing activities:Purchase
      of property and equipment
                    
                    
                    (2,239
                    )
                    
                    
                    (2,217
                    )Payment
      for technology license
                    
                    
                    (204
                    )
                    
                    
                    -Customer
      loan repayments, net
                    
                    
                    1,929
                    
                    
                    
                    633Net
      cash used in investing activities
                    
                    
                    (514
                    )
                    
                    
                    (1,584
                    )Cash
      flows from financing activities:Proceeds
      from exercise of stock options and tax collected on vesting of restricted
      stock awards
                    
                    
                    15
                    
                    
                    
                    20Reduction
      (increase) in restricted cash and cash equivalents
                    
                    
                    (33
                    )
                    
                    
                    261Borrowings
      on line of credit
                    
                    
                    4,850
                    
                    
                    
                    2,885Repayments
      on line of credit
                    
                    
                    (5,854
                    )
                    
                    
                    -Borrowings
      on long-term debt
                    
                    
                    1,765
                    
                    
                    
                    -Repayments
      on long-term debt
                    
                    
                    (1,337
                    )
                    
                    
                    (3,298
                    )Net
      cash used in financing activities
                    
                    
                    (594
                    )
                    
                    
                    (132
                    )Effect
      of exchange rate changes on cash and cash equivalents from continuing
      operations
                    
                    
                    (15
                    )
                    
                    
                    247Effect
      of exchange rate changes on cash and cash equivalents from discontinued
      operations
                    
                    
                    -
                    
                    
                    
                    (6
                    )Effect
      of exchange rate changes on cash and cash equivalents
                    
                    
                    (15
                    )
                    
                    
                    241Net
      decrease in cash and cash equivalents
                    
                    
                    (3,745
                    )
                    
                    
                    (3,271
                    )Cash
      and cash equivalents, beginning of the period
                    
                    
                    12,154
                    
                    
                    
                    13,129Cash
      and cash equivalents, end of the period
                    
                    $
                    8,409
                    
                    
                    $
                    9,858Supplemental
      cash flow information:Cash
      paid for interest expense
                    
                    $
                    270
                    
                    
                    $
                    307Cash
      paid for income taxes
                    
                    
                    800
                    
                    
                    
                    1,141




See
accompanying notes to condensed consolidated financial
statements.


5




OTIX
GLOBAL, INC.




NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


(in
thousands, except per share data)


(unaudited)




1.
BASIS OF PRESENTATION




The
accompanying unaudited condensed consolidated financial statements have been
prepared in accordance with U.S. generally accepted accounting principles for
interim financial information and with the instructions to Form 10-Q and Rule
10-01 of Regulation S-X. Accordingly, they do not include all of the information
and footnotes required by U.S. generally accepted accounting principles for
complete financial statements. In the opinion of management, all adjustments
(consisting only of normal recurring adjustments) considered necessary for a
fair presentation have been included. The results of operations for the nine
months ended September 30, 2010 are not necessarily indicative of results that
may be expected for the full year ending December 31, 2010. For further
information, refer to the consolidated financial statements and footnotes
thereto included in the Otix Global, Inc. Annual Report on Form 10-K for the
year ended December 31, 2009 as filed with the U.S. Securities and Exchange
Commission (“SEC”).




Plan of Merger.On September
13, 2010, the Company entered into a definitive agreement and plan of merger
with William Demant Holding A/S (“WDH”) and OI Merger Sub, Inc., a wholly-owned
subsidiary of WDH, pursuant to which the Company agreed to merge with and into
OI Merger Sub, Inc. in a cash transaction valued at approximately $64,200. Under
the terms of the merger agreement at closing: (i) each share of the Company’s
common stock will be exchanged for $11.01 per share in cash; (ii) all of the
Company’s outstanding stock options, whether vested or unvested, will be
cancelled and each holder of such stock options will be entitled to receive an
amount equal to the product of (A) the number of shares subject to such holder’s
stock option, multiplied by (B) $11.01 less the applicable per-share exercise
price; and (iii) each share of the Company’s restricted stock will become fully
vested free of other restrictions immediately prior to the effective time of the
merger, and will be treated in a manner consistent with the other shares of the
Company’s common stock. Completion of the transaction is subject to clearance
under the Hart-Scott-Rodino Antitrust Improvement Act of 1976 and other
customary closing conditions and is expected to occur in late November 2010. On
November 22, 2010, the shareholders approved the WDH merger
transaction.




The
merger agreement also provides that, subject to the satisfaction of certain
conditions, the Company’s board may withdraw or modify its recommendation to its
stockholders for adoption of the merger agreement. In the event that the board
withdraws or modifies its recommendation in a manner adverse to WDH and the
merger agreement is terminated, the Company may be required to pay a termination
fee of $2,000 to WDH. WDH must pay the Company a termination fee of $8,000 if
WDH is unwilling to close the merger and the Company has fulfilled its
conditions to the closing of the merger and WDH is not entitled to otherwise
terminate the merger agreement according to its terms.




With the
announcement of the sale to WDH and the decision to discontinue the Germany
business, the Company may not have sufficient cash flows to support its
operations as a stand-alone company. The Company is reducing costs to the extent
practical, yet maintaining the business for the sale to WDH. In the unlikely
event the merger with WDH is not finalized, management would endeavor to sell
the Company to another party. WDH must pay the Company a termination fee of
$8,000 if WDH is unwilling to close the merger and the Company has fulfilled its
conditions to the closing of the merger, and WDH is not entitled to otherwise
terminate the merger agreement according to its terms. In the event that the
Company receives the $8,000 from WDH, the Company would use the proceeds to
satisfy working capital and debt repayment requirements until such time as
management could sell the Company to another party. As of September 30, 2010,
outstanding borrowings on the SVB line of credit of $1,468 represented the
maximum allowable borrowing under the terms of the agreement. Including,
but not limited to, the $1,599 Germany restructuring charge, the $550 WDH
transaction related costs, and the Company’s $150 deductible under its directors
and officers liability policy related to the putative class action suit
settlement, the Company did not meet its $5,500 SVB minimum tangible net worth
covenant by approximately $150 for the month ended September 30, 2010. The
Company is in the process of working with SVB on a resolution. However, the
Company expects the merger of Otix and WDH will close in November 2010, making
the need for the further raising of capital unnecessary.




On
September 1, 2008, the Company sold one European operation and closed a second
European operation. As of September 30, 2010 and December 31, 2009, there were
no material balances related to these operations remaining in the Condensed
Consolidated Balance Sheets. These operations have been classified as
discontinued operations in the Condensed Consolidated Statements of Operations
and the Condensed Consolidated Statements of Cash Flows for the nine months
ended September 30, 2010 and 2009.




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


6




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




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




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





ThreemonthsendedSeptember30,
                      
                      
                      NinemonthsendedSeptember30,2010
                      
                      
                      2009
                      
                      
                      2010
                      
                      
                      2009Balance,
      beginning of period
                      
                      $
                      1,014
                      
                      
                      $
                      2,066
                      
                      
                      $
                      1,196
                      
                      
                      $
                      1,994Provisions
                      
                      
                      1,277
                      
                      
                      
                      2,052
                      
                      
                      
                      3,693
                      
                      
                      
                      6,387Returns
      processed
                      
                      
                      (1,322
                      )
                      
                      
                      (2,296
                      )
                      
                      
                      (3,920
                      )
                      
                      
                      (6,559
                      )Balance,
      end of period
                      
                      $
                      969
                      
                      
                      $
                      1,822
                      
                      
                      $
                      969
                      
                      
                      $
                      1,822




For the
three months ended September 30, 2010 and 2009, the Australian Government’s
Office of Hearing Services, a division of the Department of Health and Aging,
accounted for approximately 25.0% and 18.7% of the Company’s total net sales,
respectively. For the nine months ended September 30, 2010 and 2009, such sales
accounted for approximately 22.9% and 14.6% of the Company’s total net sales,
respectively. No other customer accounted for 10% or more of consolidated sales.
No single customer comprised more than 10% of accounts receivable as of
September 30, 2010 and 2009.




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




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





Accrued
warranty costs were as follows:





ThreemonthsendedSeptember30,
                    
                    
                    NinemonthsendedSeptember30,2010
                    
                    
                    2009
                    
                    
                    2010
                    
                    
                    2009Balance,
      beginning of period
                    
                    $
                    3,713
                    
                    
                    $
                    4,013
                    
                    
                    $
                    3,901
                    
                    
                    $
                    3,727Provisions
                    
                    
                    894
                    
                    
                    
                    1,072
                    
                    
                    
                    2,458
                    
                    
                    
                    3,263Costs
      incurred
                    
                    
                    (1,117
                    )
                    
                    
                    (990
                    )
                    
                    
                    (2,869
                    )
                    
                    
                    (2,895
                    )Balance,
      end of period
                    
                    $
                    3,490
                    
                    
                    $
                    4,095
                    
                    
                    $
                    3,490
                    
                    
                    $
                    4,095




Cash Equivalents. The Company
considers all short-term investments purchased with an original maturity of
three months or less to be cash equivalents. As of September 30, 2010 and
December 31, 2009, cash equivalents consisted of money market funds
totaling $2,112 and $4,860, respectively. As of September 30, 2010 and
December 31, 2009, the Company had pledged $113 and $71 of cash and cash
equivalents, respectively, as a security deposit for bankingarrangements.


7




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




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




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




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




The
Company’s money market funds totaling $2,112 as of September 30, 2010 are
recorded at fair value using Level 1 observable inputs.





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




The
Company may enter into readily marketable forward contracts with financial
institutions to minimize the short-term impact of foreign currency fluctuations
on certain intercompany balances. The Company has not designated its contracts
as hedging instruments, nor does the Company enter into contracts for trading or
speculation purposes. Gains and losses on the contracts are included in the
results of operations and offset foreign exchange gains or losses recognized on
the revaluation of certain intercompany balances. The Company’s foreign exchange
forward contracts generally mature in three months or less from the contract
date. The Company entered into foreign currency forward contracts during the
three months ended September 30, 2010 and the Company recorded a $249 loss in
Other income (expense), net in the Condensed Consolidated Statements of
Operations for the quarter ending September 30, 2010.  The contracts
expired on September 29, 2010. The Company held forward contract hedges on
€3,500 ($4,765) and Australian $2,500 ($2,405) at September 30, 2010. As of
September 30, 2010, the Company recognized an unrealized loss of $16 in
connection with its foreign currency forward contracts. The unrealized loss is
recorded in Other income (expense), net in the Condensed Consolidated Statements
of Operations, and in Other accrued liabilities in the Condensed Consolidated
Balance Sheets. The contracts will expire in the fourth quarter of 2010.
Effective in the second quarter 2008, the Company entered into an interest rate
swap agreement which effectively fixed the interest rate of the long-term debt
associated with the German acquisition at 9.59% (see Note 3 for further
details).




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





September30,
                    2010
                  
                  
                  December31,
                    2009Raw
      materials and components
                  
                  $
                  3,658
                  
                  
                  $
                  3,410Work
      in progress
                  
                  
                  91
                  
                  
                  
                  55Finished
      goods
                  
                  
                  4,179
                  
                  
                  
                  5,289Total
                  
                  $
                  7,928
                  
                  
                  $
                  8,754




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


8




ThreemonthsendedSeptember30,
                  
                  
                  NinemonthsendedSeptember30,2010
                  
                  
                  2009
                  
                  
                  2010
                  
                  
                  2009Net
      loss
                  
                  $
                  (4,747
                  )
                  
                  $
                  (2,064
                  )
                  
                  $
                  (9,218
                  )
                  
                  $
                  (21,624
                  )Foreign
      currency translation gain
                  
                  
                  2,126
                  
                  
                  
                  1,414
                  
                  
                  
                  1,217
                  
                  
                  
                  2,425Comprehensive
      loss
                  
                  $
                  (2,621
                  )
                  
                  $
                  (650
                  )
                  
                  $
                  (8,001
                  )
                  
                  $
                  (19,199
                  )





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




ThreemonthsendedSeptember30,
                  
                  
                  NinemonthsendedSeptember30,2010
                  
                  
                  2009
                  
                  
                  2010
                  
                  
                  2009Cost
      of sales
                  
                  $
                  48
                  
                  
                  $
                  63
                  
                  
                  $
                  155
                  
                  
                  $
                  164Selling,
      general and administrative
                  
                  
                  185
                  
                  
                  
                  170
                  
                  
                  
                  566
                  
                  
                  
                  758Research
      and development
                  
                  
                  41
                  
                  
                  
                  57
                  
                  
                  
                  133
                  
                  
                  
                  176Total
                  
                  $
                  274
                  
                  
                  $
                  290
                  
                  
                  $
                  854
                  
                  
                  $
                  1,098




Stock
option and restricted stock award grants were as follows:





ThreemonthsendedSeptember30,
                                        
                                        
                                        NinemonthsendedSeptember30,2010
                                        
                                        
                                        2009
                                        
                                        
                                        2010
                                        
                                        
                                        2009Awards
      Issued
                                        
                                        
                                        Fair
      Value
                                        
                                        
                                        Awards
      Issued
                                        
                                        
                                        Fair
      Value
                                        
                                        
                                        Awards
      Issued
                                        
                                        
                                        Fair
      Value
                                        
                                        
                                        Awards
      Issued
                                        
                                        
                                        Fair
      ValueStock
      options
                                        
                                        
                                        -
                                        
                                        
                                        $
                                        -
                                        
                                        
                                        
                                        233
                                        
                                        
                                        $
                                        120
                                        
                                        
                                        
                                        27
                                        
                                        
                                        $
                                        68
                                        
                                        
                                        
                                        233
                                        
                                        
                                        $
                                        120Restricted
      stock
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        54
                                        
                                        
                                        
                                        33





During
the three months ended September 30, 2010, the Company did not grant any
restricted stock awards or stock option awards. During the three months ended
June 30, 2010, the Company granted stock option awards to members of the board
of directors. The $38 fair value of the 15 options was estimated on the date of
grant based on a risk free rate of return of 2.1%, an expected dividend yield of
0.0%, volatility of 62.6%, and an expected life of 5 years. The $30 fair value
of the 12 options issued to employees during the three months ended March 31,
2010 was estimated on the date of grant based on a risk free rate of return of
2.6%, an expected dividend yield of 0.0%, volatility of 62.5%, and an expected
life of 5 years.




During
the three and nine months ended September 30, 2009, the Company granted 233
stock option awards to employees with an aggregate fair value of $120. The fair
value of the options issued during the three and nine months ended
September 30, 2009 was estimated on the date of grant based on a risk free
rate of return of 2.5%, an expected dividend yield of 0.0%, volatility of 62.8%,
and an expected life of 5 years. During the nine months ended September 30,
2009, the Company granted 54 restricted stock awards to members of the board of
directors with an aggregate fair value of $33 and no grants were made to
employees.





As of
September 30, 2010, there was $555 and $760 of unrecognized stock-based
compensation expense relating to options and restricted stock awards,
respectively, that will be recognized over a weighted-average period of 2.3 and
2.7 years, respectively.




Loss Per Common Share. Basic
loss per common share is calculated based upon the weighted average shares of
common stock outstanding during the period. Diluted loss per share is calculated
based upon the weighted average number of shares of common stock outstanding,
plus the dilutive effect of common stock equivalents calculated using the
treasury stock method. Antidilutive common stock share equivalents of 685 and
694 for the three and nine months ended September 30, 2010, respectively were
excluded from the diluted loss per share calculation. Antidilutive common stock
share equivalents of 604 and 637 for the three and nine months ended September
30, 2009, respectively were excluded from the diluted loss per share
calculation.




Income Taxes. In some
jurisdictions net operating loss carry-forwards reduce or offset tax provisions.
The Company’s income tax provision (benefit) for the three months ended
September 30, 2010 and 2009 was $23 and $115, respectively and for the nine
months ended September 30, 2010 and 2009 was ($105) and $390, respectively. The
income tax benefit for the nine months ended September 30, 2010 was principally
the result of pre-tax losses in certain foreign jurisdictions, partially offset
by alternative minimum tax in the U.S., and state taxes. Income taxes on profits
in the U.S. and a number of the Company’s foreign subsidiaries are currently
negated by its net operating loss carry-forwards.


9


Recent Accounting
Pronouncements. In January 2010, the FASB issued ASU 2010-06, “Improving Disclosures about Fair
Value Measurements.” ASU 2010-06 both expands and clarifies the
disclosure requirements related to fair value measurements. Entities are
required to disclose separately the amounts of significant transfers in and out
of Level 1 and Level 2 of the fair value valuation hierarchy and describe the
reasons for the transfers. Additionally, entities are required to disclose
information about purchases, sales, issuances, and settlements on a gross basis
in the reconciliation of Level 3 fair-value measurements. The new guidance also
clarifies existing fair-value measurement disclosure guidance about the level of
disaggregation, inputs, and valuation techniques.  The Company adopted
the new disclosures effective January 1, 2010, except for the Level 3
roll-forward disclosures. The Level 3 roll-forward disclosures will be effective
for the Company January 1, 2011.  The adoption of the ASU did not
have a material impact on the Company’s disclosures as it did not have
significant transfers in and out of Level 1 and Level 2 of the fair value
valuation hierarchy in the first half of 2010.





In
October 2009, the FASB issued ASU 2009-13,“Revenue Recognition (ASU Topic
605) – Multiple Deliverable Revenue Arrangements,” a consensus of the
FASB Emerging Issues Task Force which is effective for the Company in the first
quarter of fiscal year 2011, with early adoption permitted, modifies the fair
value requirements of ASC subtopic 605-25, “Revenue Recognition-Multiple
Element Arrangements,” by allowing the use of the “best estimate of
selling price” in addition to vendor-specific objective evidence (“VSOE”) and
verifiable objective evidence (“VOE”) (now referred to as “TPE” standing for
third-party evidence) for determining the selling price of a deliverable. A
vendor is now required to use its best estimate of the selling price when VSOE
or TPE of the selling price cannot be determined. In addition, the residual
method of allocating arrangement consideration is no longer permitted. In
October 2009, the FASB also issued ASU 2009-14, “Software (ASC Topic 985) – Certain
Revenue Arrangements That Include Software Elements,” a consensus of the
FASB Emerging Issues Task Force. This guidance modifies the scope of ASC
subtopic 965-605, “Software-Revenue
Recognition,” to exclude from its requirements (a) non-software
components of tangible products and (b) software components of tangible
products that are sold, licensed, or leased with tangible products when the
software components and non-software components of the tangible product function
together to deliver the tangible product’s essential functionality. ASU 2009-13
is required to be applied prospectively to new or materially modified revenue
arrangements in fiscal years beginning on or after June 15, 2010. This update
requires expanded qualitative and quantitative disclosures once adopted. The
Company is currently evaluating the impact of adopting this pronouncement and
does not expect the standard to have a material impact on its condensed
consolidated financial statements.





2. INTANGIBLE
ASSETS




In
accordance with the ASC 360-10, “Property, Plant and
Equipment,” long-lived assets such as property, plant, and equipment, and
purchased intangible assets subject to amortization, are amortized over their
respective estimated useful lives and are reviewed for impairment whenever
events or changes in circumstances indicate that the carrying amount of an asset
or asset group may not be recoverable. Recoverability of assets to be held and
used is measured by a comparison of the carrying amount of an asset or asset
group to estimated undiscounted future cash flows expected to be generated by
the asset or asset group. If the carrying amount of an asset or asset group
exceeds its estimated future cash flows, an impairment charge is recognized in
the amount by which the carrying amount of the asset exceeds the fair value of
the asset or asset group. The Company performs its annual impairment test in
December or when a triggering event has occurred.  The decision to
wind-down German operations represented a triggering event during the first nine
months of 2010, however, there was no deemed impairment, given that the WDH
purchase price exceeds the Company book value at September 30,
2010.




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




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




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


10





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




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




Balance as of December 31, 2009
                        
                        North
                          America
                        
                        
                        Europe
                        
                        
                        Rest-of-
                          World
                        
                        
                        TotalGoodwill
      and indefinite-lived intangible assets
                        
                        $
                        16,033
                        
                        
                        $
                        22,385
                        
                        
                        $
                        9,368
                        
                        
                        $
                        47,786Accumulated
      impairment charges
                        
                        
                        (14,632
                        )
                        
                        
                        (16,014
                        )
                        
                        
                        -
                        
                        
                        
                        (30,646
                        )1,401
                        
                        
                        
                        6,371
                        
                        
                        
                        9,368
                        
                        
                        
                        17,140Indefinite-lived
      intangible assets acquired during the year
                        
                        
                        -
                        
                        
                        
                        -
                        
                        
                        
                        18
                        
                        
                        
                        18Effect
      of exchange rate changes
                        
                        
                        -
                        
                        
                        
                        (326
                        )
                        
                        
                        808
                        
                        
                        
                        482Balance
      as of September 30, 2010Goodwill
      and indefinite-lived intangible assets
                        
                        
                        16,033
                        
                        
                        
                        22,059
                        
                        
                        
                        10,194
                        
                        
                        
                        48,286Accumulated
      impairment charges
                        
                        
                        (14,632
                        )
                        
                        
                        (16,014
                        )
                        
                        
                        -
                        
                        
                        
                        (30,646
                        )$
                        1,401
                        
                        
                        $
                        6,045
                        
                        
                        $
                        10,194
                        
                        
                        $
                        17,640




Definite-lived intangible
assets consisted of the following:





September 30,
      2010
                                        
                                        
                                        December 31,
      2009Useful
                                        
                                        Gross Carrying
                                        
                                        
                                        Accumulated
                                        
                                        
                                        Gross Carrying
                                        
                                        
                                        AccumulatedLives
                                        
                                        Value
                                        
                                        
                                        Amortization
                                        
                                        
                                        Value
                                        
                                        
                                        AmortizationPurchased
      technology and licenses
                                        
                                        3-13 years
                                        
                                        $
                                        2,181
                                        
                                        
                                        $
                                        1,472
                                        
                                        
                                        $
                                        1,976
                                        
                                        
                                        $
                                        1,357Brand
      and trade names
                                        
                                        1-3
      years
                                        
                                        
                                        129
                                        
                                        
                                        
                                        129
                                        
                                        
                                        
                                        129
                                        
                                        
                                        
                                        129Customer
      databases
                                        
                                        2-10
      years
                                        
                                        
                                        7,447
                                        
                                        
                                        
                                        6,159
                                        
                                        
                                        
                                        7,433
                                        
                                        
                                        
                                        5,940Non-compete
      agreements
                                        
                                        1-5
      years
                                        
                                        
                                        2,158
                                        
                                        
                                        
                                        1,510
                                        
                                        
                                        
                                        2,189
                                        
                                        
                                        
                                        1,285Total
                                        
                                        
                                        
                                        $
                                        11,915
                                        
                                        
                                        $
                                        9,270
                                        
                                        
                                        $
                                        11,727
                                        
                                        
                                        $
                                        8,711




11




3.
LONG-TERM DEBT




As of
September 30, 2010, the current portion of long-term debt was $4,150 and the
long-term portion was $791. Future principal payments on long-term debt
consisted of the following as of September 30, 2010:




Future
      PaymentsEffective
                                                        Interest Rate
                                                      
                                                      
                                                      Total
                                                      
                                                      
                                                      Rest of
                                                          2010
                                                      
                                                      
                                                      2011
                                                      
                                                      
                                                      2012
                                                      
                                                      
                                                      2013
                                                      
                                                      
                                                      ThereafterGerman
      bank loan
                                                      
                                                      9.59%
                                                      
                                                      
                                                      $
                                                      680
                                                      
                                                      
                                                      $
                                                      340
                                                      
                                                      
                                                      $
                                                      340
                                                      
                                                      
                                                      $
                                                      -
                                                      
                                                      
                                                      $
                                                      -
                                                      
                                                      
                                                      $
                                                      -Australian
      loans
                                                      
                                                      6.13
      - 9.19%
                                                      
                                                      
                                                      
                                                      1,871
                                                      
                                                      
                                                      
                                                      51
                                                      
                                                      
                                                      
                                                      1,190
                                                      
                                                      
                                                      
                                                      242
                                                      
                                                      
                                                      
                                                      267
                                                      
                                                      
                                                      
                                                      121Lines
      of credit
                                                      
                                                      5.35
      - 5.75%
                                                      
                                                      
                                                      
                                                      2,148
                                                      
                                                      
                                                      
                                                      2,148
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      -Leases
      and acquisition loans
                                                      
                                                      0.00
      - 12.25%
                                                      
                                                      
                                                      
                                                      242
                                                      
                                                      
                                                      
                                                      57
                                                      
                                                      
                                                      
                                                      106
                                                      
                                                      
                                                      
                                                      79
                                                      
                                                      
                                                      
                                                      -
                                                      
                                                      
                                                      
                                                      -Total
      carrying amount
                                                      
                                                      
                                                      
                                                      
                                                      $
                                                      4,941
                                                      
                                                      
                                                      $
                                                      2,596
                                                      
                                                      
                                                      $
                                                      1,636
                                                      
                                                      
                                                      $
                                                      321
                                                      
                                                      
                                                      $
                                                      267
                                                      
                                                      
                                                      $
                                                      121




The
German bank loan bears interest at the EURIBOR rate plus 4.00%. As of September
30, 2010, the balance of the loan was €500 ($680). The loan payments are €250
($340 as of September 30, 2010) per quarter. In September 2008, the Company
entered into an interest rate swap agreement with an initial notional amount of
€2,500 to be reduced €250 per quarter through January 2011. Under this
agreement the Company receives a floating rate based on the EURIBOR interest
rate, and pays a fixed rate of 9.59% on the notional amount effectively fixing
the interest rate on the Company’s German loan. Therefore, the effective
interest rate on this loan was 9.59% for the nine months ended September 30,
2010 and 2009.




The
Company entered into two additional loans in Australia during the second quarter
of 2010. The Company entered into a Bill Facility with National Australia Bank
Health (“NAB”), providing for a non-amortizing and non-revolving credit
facility, under which the Company borrowed Australian $1,000 ($883). There is a
bi-annual fee of 0.50% on the borrowed portion of the bill facility. Borrowings
under the bill facility are subject to interest at a floating rate of
approximately 6.13%, at September 30, 2010, plus an activation fee of 2.00%. The
floating rate is calculated based on the Australian Bank Bill Swap Rate plus
0.70%. The bill facility is secured by substantially all tangible Australian
assets. Covenants under this agreement require the Australian division to
maintain a minimum capital adequacy of 35% as measured on a daily basis and
reported in relation to the nine month period starting on September 30, 2010.
Additionally, the Australian division is required to maintain a minimum interest
cover ratio of 2.00 times measured every six month period starting on June 30,
2010. The Australian division is in compliance with the aforementioned covenants
as of September 30, 2010. The effective interest rate on this loan for the third
quarter of 2010 was 5.75%. The bill facility is due on April 30, 2011 and the
full amount outstanding as of September 30, 2010 is recorded as a current
liability on the Company’s Consolidated Balance Sheet. Additionally, during the
second quarter 2010, the Company entered into a four year equipment loan with
Medfin Australia Pty Ltd (“Medfin”) in which the Company borrowed Australian
$1,000 ($882) by collateralizing the loan with specific Australian tangible
assets. The Company remits monthly payments to Medfin and the effective interest
rate for the three months and nine months ended September 30, 2010 was 9.09% and
9.19%, respectively.




Acquisition
loans relate to the purchase of retail audiology practices acquired under the
Company’s retail distribution initiative. Generally, these notes are secured by
the acquired assets, subordinated to the revolving credit facility, and are due
in annual installments from the acquisition date. The final acquisition loan
payment was made in November 2010.




On
March 10, 2010, the Company finalized the Second Amendment to the Amended
and Restated Loan and Security Agreement with SVB, to renew and extend the
revolving credit facility to April 11, 2011. The credit facility is secured
by substantially all tangible U.S. assets. There is an annual fee of 0.38% on
the average unused portion of the credit facility. The amendment modified the
previous agreement to provide additional borrowing capacity of unrestricted cash
held at SVB up to $2,000, no longer reduced borrowing capacity related to
foreign currency hedging instruments, and modified the EBITDA
requirement.





At
September 30, 2010, the Company’s net borrowings on the SVB line of credit were
$1,468 and net borrowings on this line of credit at December 31, 2009 were
$3,116.  As of September 30, 2010, the interest rate on the Company’s SVB
line of credit was 5.35% and the Company’s outstanding borrowings represented
the maximum allowable borrowing under the terms of the agreement. The fair value
of the Company’s debt obligations approximates the carrying value as of
September 30, 2010. The Company notified SVB in May 2010 that compliance with
its debt covenants, as structured, would be difficult.  Subsequently,
in June 2010, the Company signed a letter of understanding with SVB in
which SVB agreed to suspend covenant testing as of May 31, 2010 and June 30,
2010, respectively, and amend the financial covenants, pending completion of a
formal loan agreement by early August 2010.  Accordingly, on August 9,
2010, the Company finalized the Second Amended and Restated Loan and Security
Agreement with SVB, under which borrowings of up to $4,000 are available.
Borrowings under the credit facility are subject to interest at the domestic
prime rate. If the adjusted quick ratio is greater than or equal to 1.00, then
the interest rate is the prime rate plus 1.00 percentage points; if the adjusted
quick ratio is less than 1.00, the interest rate is the prime rate plus 1.50
percentage points.  SVB further amended the financial covenants to
remove the EBITDA requirement, include a minimum liquidity ratio of 1.50 to 1.00
and include a minimum tangible net worth requirement of $5,500. Including,
but not limited to, the $1,599 Germany restructuring charge, the $550 WDH
transaction related costs, and the Company’s $150 deductible under its directors
and officers liability policy related to the putative class action suit
settlement, the Company did not meet its $5,500 SVB minimum tangible net worth
covenant by approximately $150 for the month ended September 30,
2010.   The Company is in the process of working with SVB on a
resolution.  However, the Company expects the merger of Otix and WDH
will close in November 2010, making the need for the further raising of capital
unnecessary.


12




During
the third quarter of 2010, the Company entered into agreement with a German bank
on a line of credit for borrowings of €500 ($680). The effective interest rate
on the German line of credit for the third quarter of 2010 was
5.75%.  The Company’s repayment on the German line of credit is due in
November 2010, but is subject to prolongation in minimum increments of one
month.  The Company plans on extending the repayment on this German
line of credit in the fourth quarter 2010. The Company’s bank debt includes a
customary material adverse change clause that allows the banks to call the
loans, if invoked. The banks have not invoked this clause. In accordance with
ASC 470-10, “Debt,” the
Company has classified the outstanding balance on the revolving credit facility
as a short-term liability as of September 30, 2010 and December 31, 2009,
respectively, due to the inability of the Company to determine the likelihood
that any future events or circumstances affecting the Company may reduce the
borrowing base availability or constitute a material adverse event under the
terms of the revolving credit facility agreement causing SVB to exercise its
right to accelerate payment of amounts due under the revolving credit facility
agreement.  Also, the Company tripped its debt covenant with SVB and
therefore, classified the  SVB revolving credit facility as a
short-term liability at September 30, 2010.  During the third quarter
of 2010, the Company paid $3,714 and borrowed $1,200 on its revolving credit
facility with SVB. Repayment and borrowings are determined on an on-going basis
due to reduced/increased borrowing capacity under the amended
agreement.





4.
LEGAL PROCEEDINGS




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




As part
of the Sanomed purchase agreement, the former owners were entitled to contingent
consideration based on the achievement of certain revenue milestones. In certain
circumstances, the former owners were entitled to contingent consideration
irrespective of the achievement of the revenue milestones. In addition to the
above noted lawsuit, two of the former owners filed suits against the Company,
one of which was settled in 2007, and the other former owner’s contingent
consideration claim against the Company for approximately €1,100 ($1,497) plus
interest, was dismissed in July 2008, with the German court rendering its
decision in favor of the Company. The former owner has appealed. The Company
continues to strongly deny the allegations contained in the former owner’s
appeal and intends to defend itself vigorously; however, litigation is
inherently uncertain and an unfavorable result could have a material adverse
effect on the Company. The Company establishes reserves when a particular
contingency is probable and estimable.





On
September 16, 2010, plaintiff Albert Goltz (“Goltz”) filed a putative class
action lawsuit challenging the Merger Agreement.  The allegations contained
in this lawsuit fall within the Company’s directors and officers liability
insurance policy and, therefore, the Company informed its insurance carrier of
the lawsuit.  The Company denies these allegations and maintains that it
has committed no violations of law or of the rules and regulations of the SEC,
nor has it breached any fiduciary duties whatsoever, nevertheless, to avoid the
inherent risks associated with litigation, on November 17, 2010, the Company
entered into a memorandum of understanding with Goltz that sets forth the
principal terms of a settlement of the lawsuit. The proposed settlement is
conditional upon, among other things, the execution of an appropriate
stipulation of settlement, consummation of the merger and final approval of the
proposed settlement by the court.  As part of the proposed settlement, the
Company made additional disclosures to its shareholders pursuant to a Form 8-K
dated November 17, 2010.  In addition, the Company will be required to pay
a $150 deductible under its directors and officers liability insurance policy,
which was accrued at September 30, 2010.




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


13




5.
RESTRUCTURING




During
2009, the Company took actions to improve profitability by: 1) reducing the
total number of employees in North America; 2) closing three U.S. retail
locations resulting in a restructuring charge of $98 and goodwill and
definite-lived intangible write-off of $135; and 3) reducing headcount and
selling two retail shops in Europe. The total restructuring charge from these
actions was $769, which included $158 in sale proceeds from the two European
shops. During the third quarter of 2010, the Company announced that it is
discontinuing selling products in the German market and will wind-down the
operation of its German subsidiary and subsequently recorded severance related
restructuring costs of $1,599. During the nine months ended September 30, 2010,
the Company also reversed accruals of $20 primarily relating to favorable lease
settlements and made payments as listed in the following table in relation to
its 2008, 2009 and 2010 restructuring charges:




Employee
                      
                      
                      Excess
                      
                      
                      ImpairmentRelated
                      
                      
                      Facilities
                      
                      
                      and Other
                      
                      
                      TotalBalance,
      December 31, 2009
                      
                      $
                      289
                      
                      
                      $
                      22
                      
                      
                      $
                      45
                      
                      
                      $
                      356Restructuring
      Charge
                      
                      
                      -
                      
                      
                      
                      (20
                      )
                      
                      
                      -
                      
                      
                      
                      (20
                      )Payments
      and foreign exchange
                      
                      
                      (193
                      )
                      
                      
                      (2
                      )
                      
                      
                      (6
                      )
                      
                      
                      (201
                      )Balance,
      March 31, 2010
                      
                      
                      96
                      
                      
                      
                      -
                      
                      
                      
                      39
                      
                      
                      
                      135Payments
      and foreign exchange
                      
                      
                      (55
                      )
                      
                      
                      -
                      
                      
                      
                      (3
                      )
                      
                      
                      (58
                      )Balance,
      June 30, 2010
                      
                      
                      41
                      
                      
                      
                      -
                      
                      
                      
                      36
                      
                      
                      
                      77Restructuring
      Charge
                      
                      
                      1,599
                      
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      1,599Payments
      and foreign exchange
                      
                      
                      79
                      
                      
                      
                      -
                      
                      
                      
                      (1
                      )
                      
                      
                      78Balance,
      September 30, 2010
                      
                      $
                      1,719
                      
                      
                      $
                      -
                      
                      
                      $
                      35
                      
                      
                      $
                      1,754




6.
DISCONTINUED OPERATIONS




In 2008,
a decision was made to divest certain European operations. The Company sold one
European operating unit and closed a second operation. These operations have
been classified as discontinued operations in the Condensed Consolidated
Statements of Operations for the nine months ended September 30, 2010 and
2009.




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





Forthethreemonthsended
                      September30,
                    
                    
                    Fortheninemonthsended
                      September30,2010
                    
                    
                    2009
                    
                    
                    2010
                    
                    
                    2009Net
      sales
                    
                    $
                    -
                    
                    
                    $
                    4
                    
                    
                    $
                    -
                    
                    
                    $
                    (54
                    )Loss
      from discontinued operations, net of zero taxes
                    
                    $
                    (1
                    )
                    
                    $
                    (2
                    )
                    
                    $
                    (8
                    )
                    
                    $
                    (12
                    )




14


7.
SEGMENT INFORMATION




As of
September 30, 2010, the Company has three operating segments for which separate
financial information is available and evaluated regularly by management in
deciding how to allocate resources and assess performance. The Company evaluates
performance principally based on net sales and operating profit.




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





North America
                  
                  
                  Europe
                  
                  
                  Rest-of-World
                  
                  
                  Unallocated
                  
                  
                  TotalThree
      months ended September 30, 2010Net
      sales to external customers
                  
                  $
                  6,266
                  
                  
                  $
                  5,806
                  
                  
                  $
                  9,847
                  
                  
                  $
                  -
                  
                  
                  $
                  21,919Operating
      profit (loss)
                  
                  
                  (2,247
                  )
                  
                  
                  (327
                  )
                  
                  
                  1,002
                  
                  
                  
                  (2,971
                  )
                  
                  
                  (4,543
                  )Income
      (loss) from continuing operations
                  
                  
                  (2,364
                  )
                  
                  
                  (405
                  )
                  
                  
                  994
                  
                  
                  
                  (2,971
                  )
                  
                  
                  (4,746
                  )Three
      months ended September 30, 2009Net
      sales to external customers
                  
                  
                  8,503
                  
                  
                  
                  6,965
                  
                  
                  
                  7,671
                  
                  
                  
                  -
                  
                  
                  
                  23,139Operating
      profit (loss)
                  
                  
                  (1,210
                  )
                  
                  
                  845
                  
                  
                  
                  1,124
                  
                  
                  
                  (2,822
                  )
                  
                  
                  (2,063
                  )Income
      (loss) from continuing operations
                  
                  
                  (1,101
                  )
                  
                  
                  804
                  
                  
                  
                  1,057
                  
                  
                  
                  (2,822
                  )
                  
                  
                  (2,062
                  )Nine
      months ended September 30, 2010Net
      sales to external customers
                  
                  
                  20,000
                  
                  
                  
                  18,178
                  
                  
                  
                  26,144
                  
                  
                  
                  -
                  
                  
                  
                  64,322Operating
      profit (loss)
                  
                  
                  (6,331
                  )
                  
                  
                  2,005
                  
                  
                  
                  2,948
                  
                  
                  
                  (7,824
                  )
                  
                  
                  (9,202
                  )Income
      (loss) from continuing operations
                  
                  
                  (6,287
                  )
                  
                  
                  1,867
                  
                  
                  
                  3,034
                  
                  
                  
                  (7,824
                  )
                  
                  
                  (9,210
                  )Nine
      months ended September 30, 2009Net
      sales to external customers
                  
                  
                  26,415
                  
                  
                  
                  27,235
                  
                  
                  
                  19,341
                  
                  
                  
                  -
                  
                  
                  
                  72,991Operating
      profit (loss)
                  
                  
                  (3,392
                  )
                  
                  
                  (9,182
                  )
                  
                  
                  2,170
                  
                  
                  
                  (10,742
                  )
                  
                  
                  (21,146
                  )Income
      (loss) from continuing operations
                  
                  
                  (3,461
                  )
                  
                  
                  (9,396
                  )
                  
                  
                  1,987
                  
                  
                  
                  (10,742
                  )
                  
                  
                  (21,612
                  )As
      of September 30, 2010Identifiable
      segment assets
                  
                  
                  23,774
                  
                  
                  
                  13,378
                  
                  
                  
                  22,602
                  
                  
                  
                  -
                  
                  
                  
                  59,754Goodwill
      and indefinite-lived intangible assets
                  
                  
                  1,401
                  
                  
                  
                  6,044
                  
                  
                  
                  10,195
                  
                  
                  
                  -
                  
                  
                  
                  17,640Long-lived
      assets
                  
                  
                  5,746
                  
                  
                  
                  335
                  
                  
                  
                  3,100
                  
                  
                  
                  -
                  
                  
                  
                  9,181As
      of December 31, 2009Identifiable
      segment assets
                  
                  
                  30,237
                  
                  
                  
                  16,431
                  
                  
                  
                  20,457
                  
                  
                  
                  -
                  
                  
                  
                  67,125Goodwill
      and indefinite-lived intangible assets
                  
                  
                  1,401
                  
                  
                  
                  6,371
                  
                  
                  
                  9,368
                  
                  
                  
                  -
                  
                  
                  
                  17,140Long-lived
      assets
                  
                  
                  5,477
                  
                  
                  
                  430
                  
                  
                  
                  2,848
                  
                  
                  
                  -
                  
                  
                  
                  8,755




The
following table represents revenues and long-lived assets that are considered
material reporting units within the Company’s segments:




Revenues
                          
                          
                          Long-livedassetsForthethreemonthsended
                            September30,
                          
                          
                          Fortheninemonthsended
                            September30,NorthAmerica
                          
                          2010
                          
                          
                          2009
                          
                          
                          2010
                          
                          
                          2009
                          
                          
                          September30,2010
                          
                          
                          December 31, 2009U.S.
      wholesale
                          
                          
                          53
                          %
                          
                          
                          52
                          %
                          
                          
                          52
                          %
                          
                          
                          56
                          %
                          
                          
                          95
                          %
                          
                          
                          92
                          %U.S.
      retail
                          
                          
                          40
                          %
                          
                          
                          39
                          %
                          
                          
                          39
                          %
                          
                          
                          34
                          %
                          
                          
                          5
                          %
                          
                          
                          7
                          %EuropeGermany
                          
                          
                          71
                          %
                          
                          
                          69
                          %
                          
                          
                          68
                          %
                          
                          
                          74
                          %
                          
                          
                          93
                          %
                          
                          
                          93
                          %Rest-of-WorldAustralia
                          
                          
                          100
                          %
                          
                          
                          100
                          %
                          
                          
                          100
                          %
                          
                          
                          100
                          %
                          
                          
                          100
                          %
                          
                          
                          100
                          %




Long-lived
assets consist of property and equipment. The majority of the Company’s assets
as of September 30, 2010 and December 31, 2009 were attributable to its
U.S. operations.


15




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




This
report contains “forward-looking statements” within the meaning of
Section 27A of the Securities Act of 1933, as amended, and Rule 175
promulgated thereunder, and Section 21E of the Securities Exchange Act of
1934, as amended, and Rule 3b-6 promulgated thereunder, that involve inherent
risks and uncertainties. Any statements about our plans, objectives,
expectations, strategies, beliefs, or future performance or events constitute
forward-looking statements. Such statements are identified as those that include
words or phrases such as “believes,” “expects,” “anticipates,” “plans,” “trend,”
“objective,” “continue” or similar expressions or future or conditional verbs
such as “will,” “would,” “should,” “could,” “might,” “may” or similar
expressions. Forward-looking statements involve known and unknown risks,
uncertainties, assumptions, estimates and other important factors that could
cause actual results to differ materially from any results, performance or
events expressed or implied by such forward-looking statements. All
forward-looking statements are qualified in their entirety by reference to the
factors discussed more fully in Item 1A of our Form 10-K for the year ended
December 31, 2009: (i) deterioration of economic conditions; (ii) our
continued losses; (iii) aggressive competitive factors;
(iv) fluctuations in our financial results; (v) our common stock could
be subject to delisting; (vi) negative impact of our recent acquisition
activities; (vii) ineffective internal financial control systems;
(viii) dependence on significant customers; (ix) dependence on
critical suppliers and contractors; (x) high levels of product returns and
repairs; (xi) inability to introduce new and innovative products;
(xii) undiscovered product errors or defects; (xiii) potential
infringement on the intellectual property rights of others;
(xiv) uncertainty of intellectual property protection; (xv) dependence
on international operations; (xvi) potential product liability;
(xvii) failure to comply with FDA regulations; (xviii) our stock price
could suffer due to sales of stock by our directors and officers; (xix) our
charter documents and shareholder agreements may prevent certain acquisitions;
and (xx) debt covenant default. In addition, risks exist in respect to the
following: (i) our proposed merger with William Demant Holding A/S may be
delayed or not occur at all;and (ii) the wind down
of our German operations to facilitate the sale of the Company will drive larger
losses and diminished cash flow should the proposed merger transaction not
close.




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




OVERVIEW




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




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





On
September 13, 2010, we announced that we entered into an Agreement and Plan of
Merger with William Demant Holding A/S (“WDH”) whereby they will acquire 100% of
our common stock for $8.60 per share and we will become a wholly-owned
subsidiary of WDH and will no longer be listed with NASDAQ.  As a
result of receiving competing bids, on October 6, 2010 we entered into a First
Amendment to the Agreement and Plan of Merger wherein WDH agreed to pay $10.00
per share and, again, on October 14, 2010, we entered into a Second Amendment to
the Agreement and Plan of Merger to increase the purchase price to $11.01 per
share.  We have filed the definitive proxy statement regarding the
merger and held a special shareholders meeting on November 22, 2010,
wherein our shareholders approved the merger.  We anticipate the
merger to be closed shortly.  Concurrent with our entry into the
merger agreement with WDH, on September 13, 2010, we announced we would
discontinue selling products in Germany and have been undertaking actions to
wind-down our operations in Germany including the related charge of $1,599 in
the third quarter of 2010.


16


Germany Legislation. Recent
legislation required that the fitting fee payments to the doctors come from the
insurance companies rather than us.  The direct payment to doctors for
fitting services under our business model was one of the keys to success for our
sales model in Germany.  The law changed the market by giving more power to
the insurers by allowing discretion as to which business models they contract
with to supply hearing aids and related services.  Insurers are the sole
gatekeepers for access to the reimbursement schemes for the end consumer. 
These changes required our German subsidiary to: a) assist the insurance
companies in addressing the new requirements for invoicing, receiving and
paying doctor’s honorarium; b) renegotiate contracts with insurance
companies; and c) negotiate contracts between and with the insurance company and
the ENT doctors.  In early 2009, we were working with insurance companies
to incorporate the legislative changes in existing contracts. One insurance
company representing approximately 25% of our 2008 German revenue refused to
enter into a contract; therefore, we filed a lawsuit in the Social Court in
Hamburg, Germany. On April 28, 2009, the Court rejected our claim to force the
company to sign a contract with us.  We subsequently filed an appeal of
this decision, which was rejected without review.  In addition, a number of
other insurance companies were unsure if they should sign a contract because
there were rumors that the newly enacted law could potentially change again,
requiring the need to renegotiate within a short period of time.  Without
renegotiated insurance contracts and the ability to pay customary fitting fees
to the ENT doctors, we experienced a substantial decline in our Germany
revenues, and cash flows from operations. As such, our revenues and cash flows
were not sufficient to support our intangibles balances. As a result, we
recognized a $14,658 non-cash write-off of our goodwill and trade name
associated with our German operation in the first quarter of 2009.





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




Prior to
our announcement to discontinue business in Germany, we were renegotiating
contracts in light of the new legislative requirements and were working to
contract with other insurance companies as well. The lack of signed
insurance contracts and the imposition of new and costly requirements on the ENT
doctors and the insurance companies as well as the uncertainty
of regulatory requirements continued to impact our German business in
the third quarter 2010. As a result of our announcement to discontinue business
in Germany and our subsequent actions to wind-down operations, we expect
negligible revenue from Germany in the future.




Germany
represented 71.3% and 69.2% of Europe segment revenues and 56.3% and 68.1%
(excluding impairment charges) of Europe segment operating profit for the three
months ended September 30, 2010 and 2009, respectively and 68.4% and 73.5% of
Europe segment revenues and 65.9% and 81.4% (excluding impairment charges) of
Europe segment operating profit for the nine months ended September 30, 2010 and
2009, respectively.




Market




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




2004
                
                
                2008
                
                
                ChangeHearing
      Loss PopulationU.S.
      households (millions)
                
                
                111.1
                
                
                
                116.1
                
                
                
                4.5%Hearing
      difficulty per 1,000 households
                
                
                283
                
                
                
                295
                
                
                
                4.2%Number
      of hearing impaired (millions)
                
                
                31.5
                
                
                
                34.3
                
                
                
                8.9%





2004
                
                
                2008
                
                
                ChangeHearing
      Aid PopulationHearing
      aid adoption rate
                
                
                23.5%
                
                
                
                24.6%
                
                
                
                4.7%Hearing
      aid owners (millions)
                
                
                7.4
                
                
                
                8.4
                
                
                
                13.5%Hearing
      impaired, non-owners (millions)
                
                
                24.1
                
                
                
                25.8
                
                
                
                7.1%




The
hearing loss population in the United States has grown to approximately 34
million. Over the last generation, the hearing loss population grew at the rate
of 1.6 times the U.S. population growth, primarily due to the aging of America.
Hearing aid adoption continues to increase slowly (now 1 in 4 people with
hearing loss) as do binaural fittings (8 out of 10). While 4 in 10 people with
moderate-to-severe hearing loss use amplification for their hearing loss, fewer
than 1 in 10 people with mild hearing loss use amplification. Hearing impaired
people in this segment, which comprise the majority of the hearing impaired
population, often do not purchase hearing aids for a variety of reasons,
including their belief that their hearing loss is not significant enough to
warrant hearing aids, their concern regarding the stigma associated with wearing
hearing aids and their perception that existing hearing aids are uncomfortable,
do not perform well, cannot solve specific hearing problems and are too
expensive.




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




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




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


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


17





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


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


·
            Our
      operations and performance depend on general economic conditions. The
      global economy is experiencing uncertainty which is causing slower
      economic activity. Such fluctuations in the global economy could cause,
      among other results, deterioration and continued decline in consumer
      spending and increases in the cost of labor and
  materials.


·
            The
      available wholesale market continues to shrink as our competitors
      implement forward integration strategies and buying groups limit the
      number of manufacturers with whom they do
  business.




Product
Developments





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




In May
2010, we launched Endura, a super-power behind-the-ear (“BTE”). This is our
first power product to meet this market segment which is estimated to be about
5% of the total hearing aid market. Endura is designed specifically to have a
broad range and can fit mild-to-profound hearing losses. Endura features our
patented sound processing, clinically proven noise reduction, and advanced
directional strategies. With its emphasis on low- and mid-frequency
amplification, Endura provides more output across these frequencies than any
other power or super-power BTE. Endura also incorporates great ease-of-use
features, such as large user controls, connectivity to external Bluetooth
devices, and integrated direct audio input.




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





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





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




The
market is using RIC and open-fit products to target the first-time hearing aid
wearer. The market for RIC and open-fit products has grown rapidly, as
illustrated by the Hearing Industries Association data. The BTE category, into
which open-fit and RIC products fall, continues to grow as a percentage of the
hearing aid market, representing in excess of 55% of the units sold in the
United States in 2008, up from 51% in 2007 and 44% in 2006.




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




Distribution
Developments




Hearing
aids are generally sold through the following distribution
channels:




·
            Independent
      retailers,




·
            Purchasing
      groups,




18




·
            Retail
    chains,




·
            Governments,




·
            Internet,
    and




·
            Manufacturer-owned
      retail.




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




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




Financial
Results




Our loss
from continuing operations of $9,210 for the nine months ended September 30,
2010, compared with a loss from continuing operations of $21,612 for the nine
months ended September 30, 2009, was primarily impacted by the following
items:




·
            During the third quarter of 2010,
      the Company announced a wind-down of its Germany operations and recorded
      restructuring charges of $1,599 related to employee severance costs. In
      addition, we recorded costs for the transaction with WDH in the third
      quarter of 2010 of $550 and a $150 deductible under our directors and
      officers liability policy related to the putative class action suit
      settlement. Also related to our Germany operation, we recorded a non-cash
      goodwill and definite-lived intangibles impairment charge in the first
      quarter of 2009 of $14,658 as a result of an adverse legal decision and
      regulatory changes in Germany previously discussed. Excluding these
      charges, the year-to-date 2010 loss from continuing operations is
      comparable to the same period for
2009.




·
            The legislative changes in
      Germany reduced our German sales and profitability. Sales in our European
      business for the nine months ended September 30, 2010 were $18,178
      compared with $27,235 for the same period in 2009, a reduction of 33.3%.
      The loss of sales in Germany was partially offset by an increase in sales
      to other European countries. Excluding the 2009 impairment charge of
      $14,658, operating profit in our Europe segment was reduced by $3,471 from
      $5,476 for the nine months ended September 30, 2009 to $2,005 for the nine
      months ended September 30, 2010.  We have been unable to reduce
      our operating expenses in Germany to the same percentage as the sales
      decline because the business requires a base level of infrastructure to
      sustain ongoing operations.




·
            A decline in year-to-date North
      America sales of 30.0% and 13.2% in wholesale and retail, respectively.
      Operating expenses decreased 25.4% for wholesale and increased 5.7% for
      retail.




·
            A reduction in corporate and
      research and development expenses of $2,918 or 27.2% for the nine months
      ended September 30, 2010 compared to the same period in
      2009.




·
            Rest-of-World sales, excluding
      foreign currency, increased 14.3% while operating expenses increased by a
      similar amount.  We continue to invest in the Rest-of-World by
      hiring more audiologists and establishing a franchise
      business.




With the
announcement of our sale to WDH and discontinuing our Germany business, we do
not have sufficient cash flows to support our operation as a stand-alone
company.  We are reducing costs to the extent practical, yet
maintaining the business for the sale to WDH.


19




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




Three months ended
                            September 30,
                          
                          
                          Nine months ended
                            September 30,2010
                          
                          
                          2009
                          
                          
                          2010
                          
                          
                          2009Net
      sales
                          
                          
                          100.0
                          %
                          
                          
                          100.0
                          %
                          
                          
                          100.0
                          %
                          
                          
                          100.0
                          %Cost
      of sales
                          
                          
                          41.7
                          %
                          
                          
                          39.2
                          %
                          
                          
                          38.6
                          %
                          
                          
                          40.1
                          %Gross
      profit
                          
                          
                          58.3
                          %
                          
                          
                          60.8
                          %
                          
                          
                          61.4
                          %
                          
                          
                          59.9
                          %Selling,
      general and administrative expense
                          
                          
                          66.9
                          %
                          
                          
                          62.9
                          %
                          
                          
                          68.5
                          %
                          
                          
                          60.5
                          %Research
      and development expense
                          
                          
                          4.8
                          %
                          
                          
                          5.8
                          %
                          
                          
                          4.7
                          %
                          
                          
                          7.2
                          %Goodwill
      and definite-lived intangibles impairment charges
                          
                          
                          -
                          
                          
                          
                          0.6
                          %
                          
                          
                          -
                          
                          
                          
                          20.3
                          %Restructuring
      charge
                          
                          
                          7.3
                          %
                          
                          
                          0.4
                          %
                          
                          
                          2.5
                          %
                          
                          
                          0.9
                          %Operating
      loss
                          
                          
                          (20.7
                          )%
                          
                          
                          (8.9
                          )%
                          
                          
                          (14.3
                          )%
                          
                          
                          (29.0
                          )%Interest
      expense
                          
                          
                          (0.3
                          )%
                          
                          
                          (0.4
                          )%
                          
                          
                          (0.2
                          )%
                          
                          
                          (0.5
                          )%Other
      income (expense), net
                          
                          
                          (0.6
                          )%
                          
                          
                          0.9
                          %
                          
                          
                          -
                          
                          
                          
                          0.4
                          %Loss
      before income taxes
                          
                          
                          (21.6
                          )%
                          
                          
                          (8.4
                          )%
                          
                          
                          (14.5
                          )%
                          
                          
                          (29.1
                          )%Provision
      (benefit) for income taxes
                          
                          
                          0.1
                          %
                          
                          
                          0.5
                          %
                          
                          
                          (0.2
                          )%
                          
                          
                          0.5
                          %Loss
      from continuing operations
                          
                          
                          (21.7
                          )%
                          
                          
                          (8.9
                          )%
                          
                          
                          (14.3
                          )%
                          
                          
                          (29.6
                          )%Loss
      from discontinued operations, net of income taxes
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -Net
      loss
                          
                          
                          (21.7
                          )%
                          
                          
                          (8.9
                          )%
                          
                          
                          (14.3
                          )%
                          
                          
                          (29.6
                          )%




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





Three months ended September30,
                          
                          
                          NinemonthsendedSeptember30,2010
                          
                          
                          2009
                          
                          
                          Change
                          
                          
                          2010
                          
                          
                          2009
                          
                          
                          ChangeNorth
    America
                          
                          $
                          6,266
                          
                          
                          $
                          8,503
                          
                          
                          
                          (26.3
                          )%
                          
                          $
                          20,000
                          
                          
                          $
                          26,415
                          
                          
                          
                          (24.3
                          )%Europe
                          
                          
                          5,806
                          
                          
                          
                          6,965
                          
                          
                          
                          (16.6
                          )%
                          
                          
                          18,178
                          
                          
                          
                          27,235
                          
                          
                          
                          (33.3
                          )%Rest-of-World
                          
                          
                          9,847
                          
                          
                          
                          7,671
                          
                          
                          
                          28.4
                          %
                          
                          
                          26,144
                          
                          
                          
                          19,341
                          
                          
                          
                          35.2
                          %Total
      net sales
                          
                          $
                          21,919
                          
                          
                          $
                          23,139
                          
                          
                          
                          (5.3
                          )%
                          
                          $
                          64,322
                          
                          
                          $
                          72,991
                          
                          
                          
                          (11.9
                          )%




The
following table reflects the significant components of sales activity for the
three months ended September 30, 2009 to the three months ended September 30,
2010.




NorthAmerica
                              
                              
                              Europe
                              
                              
                              Rest-of-World
                              
                              
                              Total$
                              
                              
                              %
                              
                              
                              $
                              
                              
                              %
                              
                              
                              $
                              
                              
                              %
                              
                              
                              $
                              
                              
                              %Sales
      for the three months ended September 30, 2009
                              
                              $
                              8,503
                              
                              
                              
                              
                              
                              
                              $
                              6,965
                              
                              
                              
                              
                              
                              
                              $
                              7,671
                              
                              
                              
                              
                              
                              
                              $
                              23,139Organic
      growth (reduction)
                              
                              
                              (2,262
                              )
                              
                              
                              (26.6
                              )%
                              
                              
                              (656
                              )
                              
                              
                              (9.4
                              )%
                              
                              
                              1,397
                              
                              
                              
                              18.2
                              %
                              
                              
                              (1,521
                              )
                              
                              
                              (6.6
                              )%Foreign
      currency
                              
                              
                              25
                              
                              
                              
                              0.3
                              %
                              
                              
                              (503
                              )
                              
                              
                              (7.2
                              )%
                              
                              
                              779
                              
                              
                              
                              10.2
                              %
                              
                              
                              301
                              
                              
                              
                              1.3
                              %Sales
      for the three months ended September 30, 2010
                              
                              $
                              6,266
                              
                              
                              
                              (26.3
                              )%
                              
                              $
                              5,806
                              
                              
                              
                              (16.6
                              )%
                              
                              $
                              9,847
                              
                              
                              
                              28.4
                              %
                              
                              $
                              21,919
                              
                              
                              
                              (5.3
                              )%





The
following table reflects the significant components of sales activity for the
nine months ended September 30, 2009 to the nine months ended September 30,
2010.




NorthAmerica
                                  
                                  
                                  Europe
                                  
                                  
                                  Rest-of-World
                                  
                                  
                                  Total$
                                  
                                  
                                  %
                                  
                                  
                                  $
                                  
                                  
                                  %
                                  
                                  
                                  $
                                  
                                  
                                  %
                                  
                                  
                                  $
                                  
                                  
                                  %Sales
      for the nine months ended September 30, 2009
                                  
                                  $
                                  26,415
                                  
                                  
                                  
                                  
                                  
                                  
                                  $
                                  27,235
                                  
                                  
                                  
                                  
                                  
                                  
                                  $
                                  19,341
                                  
                                  
                                  
                                  
                                  
                                  
                                  $
                                  72,991Organic
      growth (reduction)
                                  
                                  
                                  (6,623
                                  )
                                  
                                  
                                  (25.1
                                  )%
                                  
                                  
                                  (8,661
                                  )
                                  
                                  
                                  (31.8
                                  )%
                                  
                                  
                                  2,766
                                  
                                  
                                  
                                  14.3
                                  %
                                  
                                  
                                  (12,518
                                  )
                                  
                                  
                                  (17.2
                                  )%Foreign
      currency
                                  
                                  
                                  208
                                  
                                  
                                  
                                  0.8
                                  %
                                  
                                  
                                  (396
                                  )
                                  
                                  
                                  (1.5
                                  )%
                                  
                                  
                                  4,037
                                  
                                  
                                  
                                  20.9
                                  %
                                  
                                  
                                  3,849
                                  
                                  
                                  
                                  5.3
                                  %Sales
      for the nine months ended September 30, 2010
                                  
                                  $
                                  20,000
                                  
                                  
                                  
                                  (24.3
                                  )%
                                  
                                  $
                                  18,178
                                  
                                  
                                  
                                  (33.3
                                  )%
                                  
                                  $
                                  26,144
                                  
                                  
                                  
                                  35.2
                                  %
                                  
                                  $
                                  64,322
                                  
                                  
                                  
                                  (11.9
                                  )%




20





Net sales
from continuing operations for the three months ended September 30, 2010 of
$21,919 decreased 5.3% from net sales from continuing operations of $23,139 for
the three months ended September 30, 2009. Net sales from continuing operations
for the nine months ended September 30, 2010 of $64,322 decreased 11.9% from net
sales from continuing operations of $72,991 for the nine months ended September
30, 2009.  The decrease in the third quarter and for the year-to-date
is due to the legislative changes in Germany and their impact on our ability to
conduct business, and declines in North America unit sales and lower
wholesale average selling prices. The impact on our German business related to
legislative changes started in the second quarter of 2009, which had a more
dramatic impact each successive quarter thereafter. Partially offsetting these
reductions is a 28.4% and 35.2% increase in Rest-of-World sales in the third
quarter and year-to-date 2010, respectively.





North
America hearing aid sales of $6,266 for the three months ended September
30, 2010 were down 26.3% from the prior year three months ended September 30,
2009 sales level of $8,503. North America hearing aid sales of $20,000 for the
nine months ended September 30, 2010 were down 24.3% from the prior year nine
months ended September 30, 2009 sales level of $26,415. The decrease in sales in
the third quarter and year-to-date is due primarily to declining average selling
price in our wholesale business as a result of two factors: VA sales which have
a lower selling price and lower wholesale prices due to competitive pressures we
are seeing in the marketplace.  We also saw reductions in
year-over-year unit volume of 18.8% and 25.2%, for the three and nine months
ended September 30, 2010. We are finding increased price competition in the
wholesale market as more manufactures compete over less business in the North
American independent audiologist market due to manufacturers’ retail
acquisitions.




Europe
sales of $5,806 for the three months ended September 30, 2010 decreased 16.6%
from net sales of $6,965 for the three months ended September 30,
2009.  Europe sales of $18,178 for the nine months ended September 30,
2010 decreased 33.3% from net sales of $27,235 for the nine months ended
September 30, 2009. Europe sales were primarily impacted by the legislative
changes in Germany which were effective April 1, 2009 and impacted sales in two
ways.  First, the impact of not having contracts with the insurers
resulted in net units sold in our German operation declining 51.2% in the first
three quarters of 2010 compared to the same period in 2009.  Second,
we previously billed the insurance company the full price of a hearing aid,
which included the doctor’s fee as part of the reimbursement. The full
reimbursement was recorded as revenue and the payment to the ENT doctors as a
cost of sale. We are now only billing for the hearing aid, with the doctors
billing separately for their fitting services and no longer recording the
doctor’s fees as revenue and cost of sales.




Rest-of-World
sales of $9,847 for the three months ended September 30, 2010 increased 28.4%
from the three months ended September 30, 2009 sales of $7,671. Year-to-date
sales were $26,144 for the nine months ended September 30, 2010 increased 35.2%
from the nine months ended September 30, 2009 sales of $19,341. Third quarter
and year-to-date organic growth of 18.2% and 14.3%, respectively, was due to
having more fitters employed and additional marketing expenditures, which
translated into more sales. The Australian dollar strengthened against the U.S.
dollar for both the third quarter and year-to-date which improved sales by 10.2%
and 20.9%, respectively.




We
generally have a 60 day return policy for wholesale hearing aid sales and 30
days for retail sales. Provisions for sales returns for continuing operations
were $1,277, or 5.0% and $2,052, or 8.1% of gross hearing aid sales from
continuing operations for the three months ended September 30, 2010 and 2009,
respectively. The year-to-date provision for sales returns for continuing
operations is $3,693, or 5.4% of gross hearing aid sales, and $6,387 or 8.0% of
gross hearing aid sales from continuing operations for the nine months ended
September 30, 2010 and 2009, respectively. The percentage decrease for both the
third quarter and year-to-date ended September 30, 2010 was driven by lower
sales in wholesale, where return rates tend to be higher than in our retail
operations, and lower return rates in our wholesale operation. Retail sales are
recognized after fitting and “acceptance,” which results in lower return rates,
whereas in wholesale, revenue is recognized on shipment and a reserve is
established for expected returns. We believe that the hearing aid industry,
particularly in the U.S., experiences a high level of product returns due to
factors such as statutorily required liberal return policies and product
performance that is inconsistent with hearing impaired consumers’
expectations.





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





ThreemonthsendedSeptember30,
                                                
                                                
                                                NinemonthsendedSeptember30,2010
                                                
                                                
                                                2009
                                                
                                                
                                                2010
                                                
                                                
                                                2009Continuing
      operationsNorth
    America
                                                
                                                $
                                                2,530
                                                
                                                
                                                
                                                40.4
                                                %
                                                
                                                $
                                                4,293
                                                
                                                
                                                
                                                50.5
                                                %
                                                
                                                $
                                                9,103
                                                
                                                
                                                
                                                45.5
                                                %
                                                
                                                $
                                                14,132
                                                
                                                
                                                
                                                53.5
                                                %Europe
                                                
                                                
                                                3,764
                                                
                                                
                                                
                                                64.8
                                                %
                                                
                                                
                                                4,187
                                                
                                                
                                                
                                                60.1
                                                %
                                                
                                                
                                                11,855
                                                
                                                
                                                
                                                65.2
                                                %
                                                
                                                
                                                15,853
                                                
                                                
                                                
                                                58.2
                                                %Rest-of-World
                                                
                                                
                                                6,486
                                                
                                                
                                                
                                                65.9
                                                %
                                                
                                                
                                                5,590
                                                
                                                
                                                
                                                72.9
                                                %
                                                
                                                
                                                18,531
                                                
                                                
                                                
                                                70.9
                                                %
                                                
                                                
                                                13,712
                                                
                                                
                                                
                                                70.9
                                                %Total
      gross profit
                                                
                                                $
                                                12,780
                                                
                                                
                                                
                                                58.3
                                                %
                                                
                                                $
                                                14,070
                                                
                                                
                                                
                                                60.8
                                                %
                                                
                                                $
                                                39,489
                                                
                                                
                                                
                                                61.4
                                                %
                                                
                                                $
                                                43,697
                                                
                                                
                                                
                                                59.9
                                                %




21


Gross
profit from continuing operations of $12,780 for the three months ended
September 30, 2010 decreased 9.2% from the quarter ended September 30, 2009
gross profit of $14,070, and gross margin decreased to 58.3% from 60.8% in the
same period of 2009. Gross profit from continuing operations of $39,489 for the
nine months ended September 30, 2010 decreased 9.6% from the same period ended
September 30, 2009 gross profit of $43,697, but gross margin increased to 61.4%
from 59.9% in the same period of 2009. The decrease in gross profit for the nine
months ended September 30, 2010 compared to nine months ended September 30, 2009
is due to lower sales partially offset by a higher gross margin. The gross
margin increased due to a higher mix of retail sales, a weaker U.S. dollar and a
change in reimbursement in our German business.  Partially offsetting
this are higher warranty and material costs related to our receiver-in-canal
product family, lower average selling prices in North America, and sales to the
VA which carry a lower gross margin when compared to the balance of our business
and unfavorable manufacturing variances as a result of less
volume.  The decrease in gross margin for the three months ended
September 30, 2010 compared to the same period in 2009 is due to manufacturing
variances generated due to less unit sales and our desire to reduce
inventory.




North
America gross margin decreased to 40.4% and 45.5% for the three and nine months
ended September 30, 2010, respectively, from 50.5% and 53.5% for the three and
nine months ended September 30, 2009, respectively. The decrease in gross margin
is primarily a result of lower average selling prices, and unfavorable
manufacturing variances as a result of less volume, partially offset by an
increase in the percentage of retail sales which carry a higher gross
margin.




Europe
gross margin increased to 64.8% and 65.2% for the three and nine months ended
September 30, 2010, respectively, from 60.1% and 58.2% for the three and nine
months ended September 30, 2009, respectively. The higher gross margin is due to
higher average selling prices and a change in reimbursement for Germany.
Previously we recorded equal and offsetting reimbursement for doctor fees as net
sales and cost of sales.  As a result of the recent German
legislation, the doctors must bill and collect for their
services.  Thus, the fees are no longer recorded as a sale and cost of
sale.





Rest-of-World
gross margin decreased to 65.9% for the three months ended September 30, 2010
from 72.9% for the three months ended September 30, 2009 and remained consistent
at 70.9% for the nine months ended September 30, 2010 compared to the nine
months ended September 30, 2009. The gross margin fluctuations between the third
quarter and the year to date 2010 is due to the product mix of sales in retail,
that is higher priced sales of touch in the first part of the year, and lower
priced sales in the third quarter.  In addition, we had a significant
equipment sale to the Australian government in the third quarter of
2010.  We are a distributor for equipment manufactures in Australia,
and this business carries a much lower gross margin than our retail
business.




Provisions
for warranty for continuing operations decreased to $894 and $2,458 for the
three and nine months ended September 30, 2010 from $1,072 and $3,263 for the
three and nine months ended September 30, 2009, respectively, primarily due to
lower sales volumes and favorable repair rates, partially offset by sales of RIC
products. The receiver assembly associated with the RIC products may need to be
replaced frequently and thus the warranty per unit is higher than other products
we sell. We adjust the warranty estimates as we obtain more experience with this
product line. RIC repair costs have been lower than initially
anticipated.




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, stock-based compensation, and depreciation and amortization
expenses.




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




ThreemonthsendedSeptember30,
                                              
                                              
                                              NinemonthsendedSeptember30,2010
                                              
                                              
                                              2009
                                              
                                              
                                              2010
                                              
                                              
                                              2009Continuing operationsNorth
    America
                                              
                                              $
                                              4,776
                                              
                                              
                                              
                                              76.2
                                              %
                                              
                                              $
                                              5,270
                                              
                                              
                                              
                                              62.0
                                              %
                                              
                                              $
                                              15,473
                                              
                                              
                                              
                                              77.4
                                              %
                                              
                                              $
                                              17,290
                                              
                                              
                                              
                                              65.5
                                              %Europe
                                              
                                              
                                              2,492
                                              
                                              
                                              
                                              42.9
                                              %
                                              
                                              
                                              3,342
                                              
                                              
                                              
                                              48.0
                                              %
                                              
                                              
                                              8,232
                                              
                                              
                                              
                                              45.3
                                              %
                                              
                                              
                                              10,378
                                              
                                              
                                              
                                              38.1
                                              %Rest-of-World
                                              
                                              
                                              5,484
                                              
                                              
                                              
                                              55.7
                                              %
                                              
                                              
                                              4,466
                                              
                                              
                                              
                                              58.2
                                              %
                                              
                                              
                                              15,582
                                              
                                              
                                              
                                              59.6
                                              %
                                              
                                              
                                              11,542
                                              
                                              
                                              
                                              59.7
                                              %Corporate
                                              
                                              
                                              1,917
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              1,482
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              4,811
                                              
                                              
                                              
                                              -
                                              
                                              
                                              
                                              4,969
                                              
                                              
                                              
                                              -Total
      selling, general and administrative
                                              
                                              $
                                              14,669
                                              
                                              
                                              
                                              66.9
                                              %
                                              
                                              $
                                              14,560
                                              
                                              
                                              
                                              62.9
                                              %
                                              
                                              $
                                              44,098
                                              
                                              
                                              
                                              68.5
                                              %
                                              
                                              $
                                              44,179
                                              
                                              
                                              
                                              60.5
                                              %





The
following table reflects the components of selling, general and administrative
expense for the three months ended September 30, 2009 to the three months ended
September 30, 2010.




NorthAmerica
                                          
                                          
                                          Europe
                                          
                                          
                                          Rest-of-World
                                          
                                          
                                          Corporate
                                          
                                          
                                          Total$
                                          
                                          
                                          %
                                          
                                          
                                          $
                                          
                                          
                                          %
                                          
                                          
                                          $
                                          
                                          
                                          %
                                          
                                          
                                          $
                                          
                                          
                                          %
                                          
                                          
                                          $
                                          
                                          
                                          %Selling,
      general and administrative expense for the three months ended September
      30, 2009
                                          
                                          $
                                          5,270
                                          
                                          
                                          
                                          
                                          
                                          
                                          $
                                          3,342
                                          
                                          
                                          
                                          
                                          
                                          
                                          $
                                          4,466
                                          
                                          
                                          
                                          
                                          
                                          
                                          $
                                          1,482
                                          
                                          
                                          
                                          
                                          
                                          
                                          $
                                          14,560Organic
      growth (reduction)
                                          
                                          
                                          (505
                                          )
                                          
                                          
                                          (9.6
                                          )%
                                          
                                          
                                          (559
                                          )
                                          
                                          
                                          (16.7
                                          )%
                                          
                                          
                                          583
                                          
                                          
                                          
                                          13.1
                                          %
                                          
                                          
                                          435
                                          
                                          
                                          
                                          29.4
                                          %
                                          
                                          
                                          (46
                                          )
                                          
                                          
                                          (0.3
                                          )%Foreign
      currency
                                          
                                          
                                          11
                                          
                                          
                                          
                                          0.2
                                          %
                                          
                                          
                                          (291
                                          )
                                          
                                          
                                          (8.7
                                          )%
                                          
                                          
                                          435
                                          
                                          
                                          
                                          9.7
                                          %
                                          
                                          
                                          -
                                          
                                          
                                          
                                          -
                                          
                                          
                                          
                                          155
                                          
                                          
                                          
                                          1.0
                                          %Selling,
      general and administrative expense for the three months ended September
      30, 2010
                                          
                                          $
                                          4,776
                                          
                                          
                                          
                                          (9.4
                                          )%
                                          
                                          $
                                          2,492
                                          
                                          
                                          
                                          (25.4
                                          )%
                                          
                                          $
                                          5,484
                                          
                                          
                                          
                                          22.8
                                          %
                                          
                                          $
                                          1,917
                                          
                                          
                                          
                                          29.4
                                          %
                                          
                                          $
                                          14,669
                                          
                                          
                                          
                                          0.7
                                          %




22




The
following table reflects the components of selling, general and administrative
expense for the nine months ended September 30, 2009 to the nine months ended
September 30, 2010.




NorthAmerica
                                          
                                          
                                          Europe
                                          
                                          
                                          Rest-of-World
                                          
                                          
                                          Corporate
                                          
                                          
                                          Total$
                                          
                                          
                                          %
                                          
                                          
                                          $
                                          
                                          
                                          %
                                          
                                          
                                          $
                                          
                                          
                                          %
                                          
                                          
                                          $
                                          
                                          
                                          %
                                          
                                          
                                          $
                                          
                                          
                                          %Selling,
      general and administrative expense for the nine months ended September 30,
      2009
                                          
                                          $
                                          17,290
                                          
                                          
                                          
                                          
                                          
                                          
                                          $
                                          10,378
                                          
                                          
                                          
                                          
                                          
                                          
                                          $
                                          11,542
                                          
                                          
                                          
                                          
                                          
                                          
                                          $
                                          4,969
                                          
                                          
                                          
                                          
                                          
                                          
                                          $
                                          44,179Organic
      growth (reduction)
                                          
                                          
                                          (1,898
                                          )
                                          
                                          
                                          (11.0
                                          )%
                                          
                                          
                                          (1,844
                                          )
                                          
                                          
                                          (17.8
                                          )%
                                          
                                          
                                          1,609
                                          
                                          
                                          
                                          13.9
                                          %
                                          
                                          
                                          (158
                                          )
                                          
                                          
                                          (3.2
                                          )%
                                          
                                          
                                          (2,291
                                          )
                                          
                                          
                                          (5.2
                                          )%Foreign
      currency
                                          
                                          
                                          81
                                          
                                          
                                          
                                          0.5
                                          %
                                          
                                          
                                          (302
                                          )
                                          
                                          
                                          (2.9
                                          )%
                                          
                                          
                                          2,431
                                          
                                          
                                          
                                          21.1
                                          %
                                          
                                          
                                          -
                                          
                                          
                                          
                                          -
                                          
                                          
                                          
                                          2,210
                                          
                                          
                                          
                                          5.0
                                          %Selling,
      general and administrative expense for the nine months ended September 30,
      2010
                                          
                                          $
                                          15,473
                                          
                                          
                                          
                                          (10.5
                                          )%
                                          
                                          $
                                          8,232
                                          
                                          
                                          
                                          (20.7
                                          )%
                                          
                                          $
                                          15,582
                                          
                                          
                                          
                                          35.0
                                          %
                                          
                                          $
                                          4,811
                                          
                                          
                                          
                                          (3.2
                                          )%
                                          
                                          $
                                          44,098
                                          
                                          
                                          
                                          (0.2
                                          )%




Selling,
general and administrative expense for the three months ended September 30, 2010
of $14,669 increased by $109 or 0.7%, from the three months ended September 30,
2009 level of $14,560. Selling, general and administrative expense for the nine
months ended September 30, 2010 of $44,098 decreased $81 or 0.2% from $44,179
for the nine months ended September 30, 2009. We substantially reduced costs in
certain geographies and increased spending in others. In percentage terms, we
reduced wholesale division expenses in an amount comparable to the decline in
sales, but this was offset by increased spending in advertising costs as a
percentage of sales in our retail operation. Additionally, we reduced expenses
in our Europe operation and increased spending in Rest-of-World.  Our
focus was to invest in those markets where shareholder value would be
enhanced.  Rest-of-World selling, general and administrative expenses
increased as we invested in additional audiologists.  Corporate
expenses increased in the third quarter 2010 compared to the prior year
comparable period due to $550 in transaction related costs for pending sale to
WDH and a $150 deductible under our directors and officers liability policy
related to the putative class action suit settlement.




North
America selling, general and administrative expense for the three and nine
months ended September 30, 2010 was lower than the corresponding periods for the
previous year by $494 or 9.4% and $1,817 or 10.5%, respectively.  This
was a result of reducing headcount and discretionary spending in our wholesale
operation, including the costs of our annual audiology
convention.  However, this was partially offset by expenses for the
new Veteran Administration business of $96 and $576 for the three and nine
months ended September 30, 2010, respectively, spending for a direct to consumer
initiative of $19 and $543 for the three and nine months ended September 30,
2010, respectively, and an increase in advertising in our U.S. retail stores in
order to increase appointments.




Europe
selling, general and administrative expenses decreased $850, or 25.4% and
$2,146, or 20.7%, for the three and nine months ended September 30, 2010,
respectively. We decreased expenses primarily by reducing headcount in Europe as
a result of the reduction in Germany net sales.




Rest-of-World
selling, general and administrative expense for the three and nine months ended
September 30, 2010 increased by $1,018 and $4,040 or 22.8% and 35.0%,
respectively. The weakening of the U.S. dollar against the Australian dollar was
the primary factor relating to our growth in expenses. We also added
audiologists and marketing costs to increase sales and
profitability.





Corporate. Corporate expense
primarily consists of wages and benefits for corporate employees, select
officers, worldwide marketing efforts, and general administrative expenses not
directly related to sales.  Corporate expense of $1,917 and $4,811,
for the three and nine months ended September 30, 2010 increased $435 or 29.4%
for the three months ended September 30, 2010 over the same period in the prior
year, and decreased $158 or 3.2% for the nine months ended September 30, 2010
over the same period in the prior year.  The increase in the current
quarter was due to $550 in transaction related costs for the WDH and a $150
deductible under our directors and officers liability policy related to the
putative class action suit settlement.  For the nine months ended
September 30, 2010, year over year expenses decreased due to the reduction in
marketing spend, facility rent and stock-based compensation.





Research and Development.
Research and development expense primarily consists of wages and benefits for
research and development, engineering, regulatory and clinical personnel and
also includes consulting, intellectual property, clinical studies and
engineering support costs. Research and development expense of $1,055, or 4.8%
of net sales, for the three months ended September 30, 2010 decreased $285, or
21.3%, over the research and development expense of $1,340, or 5.8% of net
sales, for the three months ended September 30, 2009. For the nine months ended
September 30, 2010, research and development costs decreased by $2,234 to 4.7%
of net sales and resulted in a 42.6% reduction over the same period in the prior
year.  The decrease for the three and nine months ended September 30,
2010 is a result of eliminating approximately 20 positions in the second quarter
of 2009. We are outsourcing more of our research and development activities and
therefore, we expect that our royalty costs, classified in cost of sales, may
increase in the future to offset the reduced research and development
expenditures.


23


Restructuring and Impairment
Charges. In the first quarter of 2010, we reversed $20 of previously
recorded restructuring charges as a result of adjustments to previous accrual
estimates related to lease settlements. In the third quarter of 2010, we began
winding down operations in Germany and as a result we recorded restructuring
related expenses of $1,599. In the first quarter of 2009, as a result of the
German court decision previously described, we recognized a goodwill impairment
charge of $14,205 and a trade name impairment charge of $453, resulting in total
impairment charges of $14,658 related to our German operation. In the second
quarter of 2009, we took actions to improve the profitability of our operation
by reducing the total number of employees in North America and Research and
Development. Accordingly we recorded restructuring charges of $525 in the second
quarter of 2009.





Interest Expense and Other Income
(Expense), Net. Other income (expense), net, primarily consists of
foreign currency gains and losses, interest income and other non-operating gains
and losses. Interest income was lower due to lower customer loan balances and
interest expense was lower due to lower rates on outstanding debt and a lower
average balance for both the three and nine month periods ending September 30,
2010. During the third quarter 2010, the company recognized a loss in foreign
currency translation of our intercompany balances for the three months ended
September 30, 2010, whereas we recognized a gain for the three months ended
September 30, 2009.




Provision (Benefit) for Income
Taxes. In some jurisdictions net operating loss carry-forwards reduce or
offset tax provisions. We had an income tax benefit from continuing operations
for the nine months ended September 30, 2010 of $105 compared to an income tax
provision from continuing operations of $390 for the nine months ended September
30, 2009.  The income tax benefit was the result of losses in foreign
locations where we pay taxes and the Company can carry-back the losses for a tax
refund, partially offset by state taxes in the U.S. The prior year income tax
provision was principally the result of pre-tax profits in foreign
jurisdictions, amortization of goodwill, and state taxes.




LIQUIDITY
AND CAPITAL RESOURCES




Our cash
flows from operating, investing and financing activities, as reflected in the
Condensed Consolidated Statement of Cash Flows for the nine months ended
September 30, 2010 and 2009 are summarized as follows:




For the nine months ended
                    September 30,2010
                  
                  
                  2009Net
      cash used in operating activities from continuing
    operations
                  
                  $
                  (2,581
                  )
                  
                  $
                  (1,747
                  )Net
      cash used in discontinued operations
                  
                  
                  (41
                  )
                  
                  
                  (49
                  )Net
      cash used in operating activities
                  
                  
                  (2,622
                  )
                  
                  
                  (1,796
                  )Net
      cash used in investing activities
                  
                  
                  (514
                  )
                  
                  
                  (1,584
                  )Net
      cash used in financing activities
                  
                  
                  (594
                  )
                  
                  
                  (132
                  )Effect
      of exchange rate changes on cash and cash equivalents from continuing
      operations
                  
                  
                  (15
                  )
                  
                  
                  247Effect
      of exchange rate changes on cash and cash equivalents from discontinued
      operations
                  
                  
                  -
                  
                  
                  
                  (6
                  )Net
      decrease in cash and cash equivalents
                  
                  
                  (3,745
                  )
                  
                  
                  (3,271
                  )Cash
      and cash equivalents, beginning of the period
                  
                  
                  12,154
                  
                  
                  
                  13,129Cash
      and cash equivalents, end of the period
                  
                  $
                  8,409
                  
                  
                  $
                  9,858




Net cash
used in operating activities from continuing operations was $2,581 for the nine
months ended September 30, 2010. Negative cash flow resulted from a net loss
from continuing operations of $9,218 which was positively affected by certain
non-cash expenses including depreciation and amortization of $2,601, stock-based
compensation of $854, foreign currency loss of $504, and loss on disposal of
long-lived assets of $20. Positive operating cash flow also resulted from a
decrease in accounts receivable of $1,369, primarily due to improved collection
efforts and lower sales during the first three quarters of 2010, a decrease
inventory of $984, a decrease in other assets of $397, amortization of discounts
on long-term debt of $3, and accrued restructuring charges of $1,599. These
positive cash flow items were offset by a non-cash increase in deferred income
taxes of $175, a decrease in accounts payable of $1,507 and withholding taxes
remitted on stock-based awards of $20.




Net cash
used in operating activities of discontinued operations was $41 for the nine
months ended September 30, 2010.




Net cash
used in operating activities from continuing operations was $1,747 for the nine
months ended September 30, 2009. Negative cash flow resulted from a net loss of
$21,624 which was positively affected by certain non-cash expenses including
goodwill and definite-lived intangible impairment charges of $14,793 relating to
our German and U.S. retail operations, depreciation and amortization of $3,058,
share-based compensation of $1,098, foreign currency loss of $97, and the
amortization of discounts on long-term debt of $82. Positive operating cash flow
also resulted from a decrease in accounts receivable of $4,964 primarily due to
improved collection efforts and lower sales during 2009, a decrease in inventory
levels of $661, and a decrease in other assets of $440. These positive cash flow
items were offset by a decrease in accounts payable, accrued expenses and
deferred revenue of $5,150, withholding taxes remitted on share-based awards of
$38, accrued restructuring of $103, and deferred income taxes of
$40.




Net cash
used in operating activities of discontinued operations was $49 for the nine
months ended September 30, 2009.




Net cash
used in investing activities of $514 for the nine months ended September 30,
2010 resulted from the purchase of property and equipment of $2,239, and
purchase of a technology license of $204 partially offset by net customer loan
repayments of $1,929.


24




Net cash
used in investing activities from continuing operations of $1,584 for the nine
months ended September 30, 2009 resulted from the purchase of property and
equipment of $2,217 slightly offset by net customer loan repayments of
$633.





Net cash
used in financing activities of $594 for the nine months ended September 30,
2010 resulted from borrowings on the line of credit of $4,850 less repayments of
$5,854. Positive cash flows resulted from proceeds from taxes collected on the
vesting of restricted shares and exercises of options of $15, and borrowings on
long-term debt of $1,765 less repayments of $1,337 partially offset by a
transfer of $33 to restricted cash.




Net cash
used in financing activities from continuing operations of $132 for the nine
months ended September 30, 2009 resulted from borrowings on the line of credit
of $2,885, decreases in restricted cash and cash equivalents of $261 and
proceeds from tax payments received on vested restricted stock of $20, offset by
principal loan payments of $3,298.





In the
first three quarters of 2010, we borrowed $4,850 on our revolving credit
facility and repaid $5,854, for a net decrease of $1,004. In the second and
third quarters of 2010 we borrowed $1,803 on two notes in Australia and $645 on
a revolving instrument in Germany. Our bank debt agreements include a customary
material adverse change clause that allows the banks to call the loans, if
invoked. The banks have not invoked such clauses.




With the
announcement of our sale to WDH and discontinuing our Germany business, we may
not have sufficient cash flows to support our operations as a stand-alone
company.  We are reducing costs to the extent practical, yet
maintaining the business for the sale to WDH.  In the unlikely event
the merger with WDH is not finalized, we would endeavor to sell the Company to
another party.  WDH must pay us a termination fee of $8,000 if WDH is
unwilling to close the merger and we have fulfilled our conditions to the
closing of the merger, and WDH is not entitled to otherwise terminate the merger
agreement according to its terms. In the event that we receive the $8,000 from
WDH, we would use the proceeds to satisfy working capital and debt repayment
requirements until such time as we could sell the Company to another
party.  As of September 30, 2010, our outstanding borrowings on our
SVB line of credit of $1,468 represented the maximum allowable borrowing under
the terms of the agreement.  Including, but not limited to, the
$1,599 Germany restructuring charge, the $550 WDH transaction related costs, and
our $150 deductible under the directors and officers liability policy related to
the putative class action suit settlement, we did not meet our $5,500 SVB
minimum tangible net worth covenant by approximately $150 for the month ended
September 30, 2010.   We are in the process of working with SVB
on a resolution.  However, we expect the merger of Otix and WDH will
close in November 2010, making the need for the further raising of capital
unnecessary.




Contractual
Obligations




As of
September 30, 2010, we had uncertain tax positions of $265, of which $243 is
recorded as a liability and which could result in cash outlays in the event of
unfavorable taxing authority rulings.




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





RECENT
ACCOUNTING PRONOUNCEMENTS




In
January 2010, the FASB issued ASU 2010-06, “Improving Disclosures about Fair
Value Measurements,” ASU 2010-06 both expands and clarifies the
disclosure requirements related to fair value measurements. Entities are
required to disclose separately the amounts of significant transfers in and out
of Level 1 and Level 2 of the fair value valuation hierarchy and describe the
reasons for the transfers. Additionally, entities are required to disclose
information about purchases, sales, issuances, and settlements on a gross basis
in the reconciliation of Level 3 fair-value measurements. The new guidance also
clarifies existing fair-value measurement disclosure guidance about the level of
disaggregation, inputs, and valuation techniques.  We adopted the new
disclosures effective January 1, 2010, except for the Level 3 roll-forward
disclosures. The Level 3 roll-forward disclosures will be effective for us
January 1, 2011.  The adoption of the ASU did not have a material
impact on our disclosures as it did not have any significant transfers in and
out of Level 1 and Level 2 of the fair value valuation hierarchy in the first
half of 2010.





In
October 2009, the FASB issued ASU 2009-13,“Revenue Recognition (ASU Topic
605) – Multiple Deliverable Revenue Arrangements,” a consensus of the
FASB Emerging Issues Task Force which is effective for us in the first quarter
of fiscal year 2011, with early adoption permitted, modifies the fair value
requirements of ASC subtopic 605-25,“Revenue Recognition-Multiple
Element Arrangements,” by allowing the use of the “best estimate of
selling price” in addition to vendor-specific objective evidence (“VSOE”) and
verifiable objective evidence (“VOE”) (now referred to as “TPE” standing for
third-party evidence) for determining the selling price of a deliverable. A
vendor is now required to use its best estimate of the selling price when VSOE
or TPE of the selling price cannot be determined. In addition, the residual
method of allocating arrangement consideration is no longer permitted. In
October 2009, the FASB also issued ASU 2009-14, “Software (ASC Topic 985) – Certain
Revenue Arrangements That Include Software Elements,” a consensus of the
FASB Emerging Issues Task Force. This guidance modifies the scope of ASC
subtopic 965-605, “Software-Revenue
Recognition,” to exclude from its requirements (a) non-software
components of tangible products and (b) software components of tangible
products that are sold, licensed, or leased with tangible products when the
software components and non-software components of the tangible product function
together to deliver the tangible product’s essential functionality. ASU 2009-13
is required to be applied prospectively to new or materially modified revenue
arrangements in fiscal years beginning on or after June 15, 2010. This update
requires expanded qualitative and quantitative disclosures once adopted. We are
currently evaluating the impact of adopting this pronouncement and do not expect
the standard to have a material impact on the condensed consolidated financial
statements.


25




ITEM
3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS




Interest Rate Risk. We
generally invest our cash in money market funds and corporate debt securities.
These are subject to minimal credit and market risk. As of September 30, 2010,
we had $2,112 held in commercial money market instruments that carry an
effective interest rate of 0.25%. The interest rates on our customer advances
approximate the market rates for comparable instruments and are
fixed.




As of
September 30, 2010 we had $680, in short-term bank debt that bears interest at
the EURIBOR rate plus 4.00%. In addition, we had $970, in short-term bank debt
that bears interest at the Australian Bank Bill Swap Rate plus 0.70%, as well as
$901, in short-term and long-term bank debt on our equipment loan in Australia
that bears interest at 9.19%.





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




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




Our
foreign exchange forward contracts generally mature in three months or less from
the contract date. We entered into foreign currency forward contracts during the
three months ended September 30, 2010 and recorded a $249 loss in Other income
(expense), net in the Condensed Consolidated Statements of Operations for the
quarter ending September 30, 2010.  The contracts expired on September
29, 2010. We held forward contract hedges on €3,500 ($4,765) and Australian
$2,500 ($2,405) at September 30, 2010. As of September 30, 2010, we recognized
an unrealized loss of $16 in connection with our foreign currency forward
contracts. The unrealized loss is recorded in Other income (expense), net in the
Condensed Consolidated Statements of Operations, and in Other accrued
liabilities in the Condensed Consolidated Balance Sheets. The contracts will
expire in the fourth quarter of 2010.




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




Foreign Currency Risk. We face
foreign currency risks primarily as a result of the revenues we derive from
sales made outside the U.S., expenses incurred outside the U.S., and from
intercompany account balances between our U.S. parent and our non-U.S.
subsidiaries. For the three months ended September 30, 2010, approximately
73.5% of our net sales and 55.7% of our operating expenses were denominated in
currencies other than the U.S. dollar. For the nine months ended September
30, 2010, approximately 71.7% of our net sales and 55.5% of our operating
expenses were denominated in currencies other than the U.S. dollar. For the
three months ended September 30, 2009, approximately 63.3% of our net sales and
53.6% of our operating expenses were denominated in currencies other than the
U.S. dollar.  For the nine months ended September 30, 2009,
approximately 63.8% of our net sales and 49.6% of our operating expenses were
denominated in currencies other than the U.S. dollar.




Inventory
purchases were transacted in U.S. dollars. The local currency of each foreign
subsidiary is considered the functional currency, and revenue and expenses are
translated at average exchange rates for the reported periods. Therefore, our
foreign sales and expenses will be higher in a period in which there is a
weakening of the U.S. dollar and will be lower in a period in which there is a
strengthening of the U.S. dollar. The Australian dollar and Euro are our most
significant foreign currencies. Given the uncertainty of exchange rate
fluctuations and the varying performance of our foreign subsidiaries, we cannot
estimate the affect of these fluctuations on our future business, results of
operations and financial condition. Fluctuations in the exchange rates between
the U.S. dollar and other currencies could effectively increase or decrease the
selling prices of our products in international markets where the prices of our
products are denominated in U.S. dollars. 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
nine months ended September 30, 2010 and 2009, average currency exchange rates
to convert one U.S. dollar into each local currency for which we had sales of
over $5,000 by quarter were as follows:





2010
                  
                  
                  2009Euro
                  
                  
                  0.76
                  
                  
                  
                  0.73Australian
      dollar
                  
                  
                  1.12
                  
                  
                  
                  1.34




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ITEM 4.
            CONTROLS AND
      PROCEDURES




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




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




PART
II - OTHER INFORMATION




ITEM 1.
            LEGAL
      PROCEEDINGS




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




As part
of the Sanomed purchase agreement, the former owners were entitled to contingent
consideration based on the achievement of certain revenue milestones. In certain
circumstances, the former owners were entitled to contingent consideration
irrespective of the achievement of the revenue milestones. In addition to the
above noted lawsuit, two of the former owners filed suit against us, one of
which was settled in 2007, and the other former owner’s contingent consideration
claim against us for approximately €1,100 ($1,497) plus interest was dismissed
on July 2008, with the German court rendering its decision in our favor. The
former owner has appealed. We continue to strongly deny the allegations
contained in the former owner’s appeal and intend to vigorously defend
ourselves; however, litigation is inherently uncertain and an unfavorable result
could have a material adverse effect. We establish liabilities when a particular
contingency is probable and estimable.




On
September 16, 2010, plaintiff Albert Goltz (“Goltz”) filed a putative class
action lawsuit challenging the Merger Agreement.  The allegations contained
in this lawsuit fall within our directors and officers liability insurance
policy and, therefore, we informed our insurance carrier of the lawsuit. 
We deny these allegations and maintain that we have committed no violations of
law or of the rules and regulations of the SEC, nor have we breached any
fiduciary duties whatsoever, nevertheless, to avoid the inherent risks
associated with litigation, on November 17, 2010, we entered into a memorandum
of understanding with Goltz that sets forth the principal terms of a settlement
of the lawsuit. The proposed settlement is conditional upon, among other things,
the execution of an appropriate stipulation of settlement, consummation of the
merger and final approval of the proposed settlement by the court.  As part
of the proposed settlement, we made additional disclosures to our shareholders
pursuant to a Form 8-K dated November 17, 2010.  In addition, we will be
required to pay a $150 deductible under our directors and officers liability
insurance policy.





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




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




ITEM 1-A.
            RISK
    FACTORS




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


27




Germany
Legislation




Recent
legislation required that the fitting fee payments to the doctors come from the
insurance companies rather than us.  The direct payment to doctors for
fitting services under our business model was one of the keys to success for our
sales model in Germany.  The law changed the market by giving more power to
the insurers by allowing discretion as to which business models they contract
with to supply hearing aids and related services.  Insurers are the sole
gatekeepers for access to the reimbursement schemes for the end consumer. 
These changes required our German subsidiary to: a) assist the insurance
companies in addressing the new requirements for invoicing, receiving and
paying doctor’s honorarium; b) renegotiate contracts with insurance
companies; and c) negotiate contracts between and with the insurance company and
the ENT doctors.  In early 2009, we were working with insurance companies
to incorporate the legislative changes in existing contracts. One insurance
company representing approximately 25% of our 2008 German revenue refused to
enter into a contract; therefore, we filed a lawsuit in the Social Court in
Hamburg, Germany. On April 28, 2009, the Court rejected our claim to force the
company to sign a contract with us.  We subsequently filed an appeal of
this decision, which was rejected without review.  In addition, a number of
other insurance companies were unsure if they should sign a contract because
there were rumors that the newly enacted law could potentially change again,
thus requiring the need to renegotiate within a short period of time. 
Without renegotiated insurance contracts, and the ability to pay customary
fitting fees to the ENT doctors, we experienced a substantial decline in our
Germany revenues, and determined that cash flows of the operation would not be
sufficient to support our intangibles balances. As a result, we recognized a
$14,658 non-cash write-off of our goodwill and trade name associated with our
German operation in the first quarter of 2009.





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




Prior to
our announcement to discontinue business in Germany, we were renegotiating
contracts in light of the new legislative requirements and were working to
contract with other insurance companies as well. The lack of signed
insurance contracts and the imposition of new and costly requirements on the ENT
doctors and the insurance companies as well as the uncertainty
of regulatory requirements continued to impact our German business in
third quarter 2010. As a result of our announcement to discontinue business in
Germany and our subsequent actions to wind-down operations, we expect negligible
revenue from Germany in the future. We do not have sufficient long-term cash
flow from our divisions to cover our general and administrative and research and
development expenses to maintain a viable stand-alone entity, thereby
necessitating the sale of the Company.





Germany
represented 71.3% and 69.2% of Europe segment revenues and 56.3% and 68.1%
(excluding impairment charges) of Europe segment operating profit for the three
months ended September 30, 2010 and 2009, respectively and 68.4% and 73.5% of
Europe segment revenues and 65.9% and 81.4% (excluding impairment charges) of
Europe segment operating profit for the nine months ended September 30, 2010 and
2009, respectively.





Merger
with William Demant Holding A/S





Our
proposed merger with WDH may be delayed or not occur at all for a variety of
reasons, including the possibility that the merger agreement is terminated prior
to the completion of the merger. If our acquisition by WDH is not completed as
expected, our stock price, business and results of operations may
suffer.




ITEM 4.
            RESERVED




ITEM 6.
            EXHIBITS




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




Exhibit #
                  
                  Description2.0
                  
                  Definitive
      Agreement and Plan of Merger with William Demant Holding A/S (filed on our
      Form 8-K on September 13, 2010 and incorporated herein by
      reference).2.1
                  
                  Announcement
      of Wind-down of Operations in Germany (filed on our Form 8-K on September
      17, 2010 and incorporated herein by reference).2.2
                  
                  GN
      ReSound proposal to purchase OTIX at $10.00 per common share (filed on our
      Form 8-K on September 29, 2010 and incorporated herein by
      reference).2.3
                  
                  Amendment
      to the Agreement and Plan of Merger with William Demant Holding A/S (filed
      on our Form 8-K on October 6, 2010 and incorporated herein by
      reference).






28




2.4
                  
                  Revised
      proposal from GN ReSound A/S to acquire Otix at a price of $11.01 per
      common share (filed on our Form 8-K on October 13, 2010 and incorporated
      herein by reference).2.5
                  
                  Second
      Amendment to the Agreement and Plan of Merger with William Demant Holding
      A/S (filed on our Form 8-K on October 19, 2010 and incorporated herein by
      reference).31.1
                  
                  Certification
      of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley
      Act of 2002.31.2
                  
                  Certification
      of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley
      Act of 2002.32
                  
                  Certification
      of Chief Executive Officer and Chief Financial Officer Pursuant to 18
      U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act
      of 2002.99.1
                  
                  Putative
      Class Action Suit Settlement (filed on our Form 8-K on November 18, 2010
      and incorporated herein by
reference).


29





SI
GNATURE




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:
November 22, 2010




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




30