U.S.
SECURITIES AND EXCHANGE COMMISSION
Washington,
D.C. 20549

FORM
10-QSB

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

**For
the quarterly period ended March 31, 2005**
OR
 ̈TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES
EXCHANGE ACT OF 1934
**Commission
file number 000-49636**

**VIKING
SYSTEMS, INC.**
(Name of
Small Business Issuer as specified in its charter)
 Nevada
    
    86-0913802(State
      or other jurisdiction of
    
    (I.R.S.
      employerincorporation
      or organization)
    
    identification
      No.)
 
 7514
Girard Ave, Suite 1509, La Jolla, CA 92037
 (Address
of principal executive offices)
 
 Registrant's
telephone no., including area code: (858) 456-6608
 
 N/A
 Former
name, former address, and former fiscal year, if changed since last
report.
 
 Securities
registered pursuant to Section 12(b) of the Exchange Act: None
 
 Securities
registered pursuant to Section 12(g) of the Exchange Act: $.001 Par Value Common
Stock
 
 Check
whether the Issuer (1) has filed all reports required to be filed by Section 13
or 15(d) of the Exchange Act 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. (1) Yes ý No   ̈ (2) Yes ý No  ̈ .
 
 Indicate
by check mark whether the registrant is an accelerated filer (as defined in rule
12b-2 of the Exchange Act). Yes  ̈ No ý
 
 Common
Stock outstanding at May 2, 2005, 31,900,300 shares of $.001 par value Common
Stock.
 
 
 DOCUMENTS
INCORPORATED BY REFERENCE: NONE
 
   
   **FORM
10-QSB**
 
 **FINANCIAL
STATEMENTS AND SCHEDULES**
 **VIKING
SYSTEMS, INC.**
 
 **For
the Quarter ended March 31, 2005**
 
 The
following financial statements and schedules of the registrant are submitted
herewith:
 
 **PART
I - FINANCIAL INFORMATION**
 Page of
 Form
10-QSB
 
 Item
      1.
    Financial
      Statements:Unaudited
      Balance Sheet at March 31, 2005
    1Unaudited
      Statement of Operations for the Three Months
      Ended
      March 31, 2005 and 2004
    2Unaudited
      Statement of Cash Flows for the Three Months
      Ended
      March 31, 2005 and 2004
    3Notes
      to Financial Statements
    4 -
      8Item
      2.
    Management's
      Discussion and Analysis of Financial Condition
      and
      Results of Operations
    8Item
      3.
    Controls
      and Procedures, Evaluation of Disclosure Controls and
      Procedures
    18
 
 
 **PART
II - OTHER INFORMATION**
 
 Page
 
 Item
      1.
    Legal
      Proceedings
    19Item
      2.
    Unregistered
      Sales of Equity Securities and Use of Proceeds.
    19Item
      3.
    Defaults
      Upon Senior Securities
    20Item
      4.
    Submission
      of Matters to a Vote of Security Holders
    20Item
      5.
    Other
      Information
    20Item
      6.
    Exhibits
    20
 
 
 
   
   **PART
I - FINANCIAL INFORMATION**
 
 **ITEM
1: FINANCIAL STATEMENTS**
 
 **VIKING
SYSTEMS, INC.**
 **Unaudited
Balance Sheet**
 **March
31, 2005**
 
 **Assets**Current
      assets:Cash
      and cash equivalents
    $
    1,013,252Accounts
      receivable, net
    
    465,765Inventories
    
    715,093Prepaids
      and other current assets
    
    116,323Total
      current assets
    
    2,310,433Property
      and equipment, net
    
    274,316$
    2,584,749**Liabilities
      and Stockholders' Deficit**Current
      liabilities:Accounts
      payable
    $
    291,679Accrued
      expenses
    
    464,040Deferred
      revenue
    
    126,500Short-term
      bank borrowings
    
    362,039Convertible
      notes payable net of debt discount of $825,000
    
    1,925,000Total
      current liabilities
    
    3,169,258Commitment
      and contingencies
    
    -Stockholders'
      deficit:Preferred
      stock, $.001 par value, 25,000,000 sharesauthorized,
      no shares issued and outstanding
    
    -Common
      stock, $.001 par value, 100,000,000 sharesauthorized;
      31,900,300 shares issued and outstanding
    
    31,900Additional
      paid-in capital
    
    4,547,589Accumulated
      deficit
    
    (5,163,998)Total
      stockholders' deficit
    
    (584,509)$
    2,584,749
    See
accompanying notes to financial statements
 1
   **VIKING
SYSTEMS, INC.**
 **Unaudited
Statement of Operations**
 **Three
Months Ended March 31, 2005 and 2004**
 
 
 **Three
      Months Ended March 31,****2005**
    
    **2004**Sales,
      net
    $
    876,403
    $
    -Cost
      of sales
    
    619,225
    
    -Gross
      profit
    
    257,178
    
    -Operating
      expenses:General
      and administrative
    
    491,767
    
    111,676Selling
      and marketing
    
    473,816
    
    -Research
      and development
    
    191,376
    
    -Total
      operating expenses
    
    1,156,959
    
    111,676Operating
      loss
    
    (899,781)
    
    (111,676)Other
      income (expense):Interest
      expense
    
    (1,948,797)
    
    -Total
      other income (expense)
    
    (1,948,797)
    
    -Net
      loss
    $
    (2,848,578)
    $
    (111,676)Net
      loss per commonshare
      - basic and diluted
    $
    (0.09)
    $
    (0.02)Weighted
      average shares - basic
    
    30,737,000
    
    6,295,000Weighted
      average shares - diluted
    
    30,737,000
    
    6,295,000
 
   See
accompanying notes to financial statements
 2
   **VIKING
SYSTEMS, INC.**
 **Unaudited
Statement of Cash Flows**
 **Three
Months Ended March 31,**
 
 **2005**
    
    **2004****Cash
      flows from operating activities:**Net
      loss
    $
    (2,848,578)
    $
    (111,676)Adjustment
      to reconcile net loss to net cashused
      in operating activities:Depreciation
      and amortization
    
    44,777
    
    569Interest
      expense from beneficial conversion feature
    
    1,925,000
    
    -Change
      in operating assets and liabilities:Accounts
      receivable, net
    
    (187,998)
    
    -Inventories,
      net
    
    (48,005)
    
    -Prepaids
      and other current assets
    
    29,219
    
    -Accounts
      payable
    
    (1,249,275)
    
    44,389Accrued
      expenses
    
    129,551
    
    -Deferred
      revenue
    
    (32,650)
    
    -Net
      cash used in operating activities
    
    (2,237,959)
    
    (66,718)**Cash
      flows from investing activities:**Purchase
      of property and equipment
    
    (41,006)
    
    (6,832)**Cash
      flows from financing activities:**Net
      change in short-term bank borrowings
    
    302,824
    
    -Proceeds
      from issuance of preferred stock
    
    -
    
    400,000Proceeds
      from convertible debt
    
    2,750,000
    
    -Proceeds
      from related-party note payable
    
    100,000
    
    -Net
      cash provided by financing activities
    
    3,152,824
    
    400,000Net
      increase in cash and cash equivalents
    
    873,859
    
    326,450Cash
      and cash equivalents at beginning of period
    
    139,393
    
    35,525Cash
      and cash equivalents at end of period
    
    1,013,252
    
    361,975**Supplemental
      disclosure of cash flow information:**Cash
      paid during the period for:Interest
    $
    23,797
    $
    -Income
      taxes
    $
    -
    $
    -
 
 During
the three months ended March 31, 2005 the Company:
 
 ·
    Allocated
      $825,000 of the proceeds from a convertible note payable to the value of
      the warrants issued, recording it as a debt
discount.
 
 ·
    Converted
      a $500,000 note payable and $16,659 of accrued interest into 1,291,650
      shares of common stock.
 
   See
accompanying notes to financial statements
 3
   
 **VIKING
SYSTEMS**
 **Notes
to Financial Statements**
 **Three
Months Ended March 31, 2005 and 2004**
 
 **1.
Interim Financial Statements**
 
 The
financial statements for the three months ended March 31, 2005 and 2004 are
unaudited. However, management, in its opinion, has made all adjustments
(consisting only of normal recurring accruals) necessary to present fairly the
financial position, results of operations and cash flows for the periods
presented. The financial statements and notes thereto should be read in
conjunction with the financial statements and notes for the years ended
December 31, 2004 and 2003, included in the Company’s Form 10-KSB filed on
March 31, 2005 with the Securities and Exchange Commission. The results of
operations and cash flows for the three months ended March 31, 2005, are not
necessarily indicative of results for the year ending December 31,
2005.
 
 **2.
Stock-Based Compensation**
 
 The
Company accounts for its employee stock-based compensation plans using the
intrinsic value method, as prescribed by APB Opinion No. 25, *Accounting
for Stock Issued to Employees* , and
related interpretations. Accordingly, the Company records deferred compensation
costs related to its employee stock options when the current market price of the
underlying stock exceeds the exercise price of each stock option on the
measurement date (usually the date of grant). The Company records and measures
deferred compensation for stock options granted to non-employees, other than
members of the Company's Board of Directors, using the fair value based method.
Deferred compensation is expensed on a straight-line basis over the vesting
period of the related stock option. During the periods ended March 31, 2005 and
2004, the Company did not grant any stock options to employees or members of the
Company's Board of Directors with exercise prices below the market price on the
measurement date.
 
 An
alternative method to the intrinsic value method of accounting for stock-based
compensation is the fair value based method prescribed by Statement of Financial
Accounting Standards (SFAS) No. 123, "Accounting for Stock-Based Compensation,"
as amended by SFAS No. 148, "Accounting for Stock-Based Compensation -
Transition and Disclosure." If the Company used the fair value based method, the
Company would be required to record deferred compensation based on the fair
value of the stock option at the date of grant as computed using an
option-pricing model, such as the Black-Scholes option pricing model. The
deferred compensation calculated under the fair value based method would then be
amortized over the vesting period of the stock option.
 
 The following
table illustrates the effect on net loss and net loss per share as if the
Company had elected to use the fair value based method to account for its
employee stock-based compensation.
 
 
 
 4
 
 
 **2.
Stock-Based Compensation -** ***Continued***
 **Three
      Months Ended March 31,****2005**
    **2004**Net
      loss, as reported
    $
    (2,848,578)
    $
    (111,676)Deduct:
      Total stock-based employee compensation expense determined under fair
      value based method for all awards, net of related tax
    effects
    
    (15,898)
    
    (6,021)Pro
      forma net loss
    $
    (2,864,476)
    $
    (117,697)Earnings
      per share-Basic
      and diluted - as Reported
    $
    (0.09)
    $
    (0.02)Basic
      and diluted -
      pro
      forma
    $
    (0.09)
    $
    (0.02)
  The fair
value of each option grant is estimated at the date of grant using the
Black-Scholes option pricing model with the following assumptions:
 **March
      31,****2005**
    **2004**Expected
      dividend yield
    $
    -
    $
    -Expected
      stock price volatility
    
    36.11%
    
    33.85%Risk-free
      interest rate
    
    4.17%
    
    2.0%Expected
      life of options
    
    10
      years
    
    4
      years
 The
weighted average fair value of options granted during the three months ended
March 31, 2005 is $.17. There were no options issued during the three months
ended March 31, 2004.
 
   5
  **3.
Going Concern**
 
 The
accompanying financial statements have been prepared on a going concern basis,
which contemplates the realization of assets and the satisfaction of liabilities
in the normal course of business. Historically, the Company has not demonstrated
the ability to generate sufficient cash flows from operations to satisfy its
liabilities and sustain operations, and the Company has incurred significant
losses. These factors raise substantial doubt about the Company’s ability to
continue as a going concern.
 
 The Company’s
continuation as a going concern is dependent on its ability to generate
sufficient income and cash flow to meet its obligations on a timely basis and/or
obtain additional financing as may be required.
 
 During the
first quarter of 2005, the Company raised approximately $2,750,000 through the
issuance of convertible notes (the “Notes”). The Notes mature 12 months from the
date of issuance, accrue interest at 10% per annum, and are secured by all of
the assets of the Company. The notes also may be converted, at the option of the
Investors, into shares of common stock of the Company at a conversion price of
$.20 per share. The conversion price is subject to adjustment based on certain
conditions of the Security Purchase Agreement. The Company may require
conversion of the Notes if the Company raises $3 million in public or private
equity offerings, at a price equal to or greater than $.30 per share of common
stock, within 3 months of the date of issuance of the Notes. In connection with
the issuance of the Notes, the Company also issued warrants to purchase common
stock at a price of $.40 per share (subject to adjustment upon certain
conditions pursuant to the terms of the Security Purchase Agreement). The
warrants are exercisable for a period of 42 months from the date of issuance.
Viking has agreed to register with the Securities and Exchange Commission and
applicable state securities agencies, the shares of common stock that are
issuable upon the conversion of the Notes and the shares of common stock that
underline the Warrants.
 
 In January
2005, the Company received a $200,000 line of credit from a bank, secured by a
certificate of deposit of a significant stockholder. In addition, the Company
has a bank line of credit that allows the Company to borrow up to 80% of the
outstanding accounts receivable, up to a maximum amount of $400,000. This
agreement expires in September 2005 and is subject to annual
renewals.
 
 Management
believes that in order to continue its operations, development of its products,
and implementation of its business plan, the Company will need additional
financing. The Company is pursuing additional financing through a private
placement offering of its common stock in which it is attempting to raise
approximately $3 million during 2005. Additionally, the Company is continuing
its efforts to increase revenues by obtaining new customers and to minimize
operating costs. There can be no assurance that the Company will be successful
in obtaining additional financing or in its efforts to increase revenues and
decrease operating costs. If the Company is unable to obtain additional
financing, it may be required to reduce operations, reduce or discontinue
further research and development, and/or reduce or eliminate further acquisition
activities.
 
 
   6
   **4.
Loss Per Share**
 
 The
computation of basic loss per common share is computed using the weighted
average number of common shares outstanding during each period.
 
 The
computation of diluted loss per common share is based on the weighted average
number of shares outstanding during the period plus common stock equivalents
which would arise from the exercise of stock options using the treasury stock
method and the conversion of convertible instruments. Options to purchase
2,846,000 shares of common stock at prices ranging from $.02 to $.65, and debt
convertible into 13,750,000 shares of common stock were outstanding at March 31,
2005, but were not included in the diluted loss per share calculation because
the effect would have been antidilutive.
 
 **5.
Convertible Notes Payable**
 
 During
the quarter ended March 31, 2005, the company raised $2,750,000 through the
issuance of convertible notes (the “Notes”). The Notes mature 12 months from the
date of issuance, accrue interest at 10% per annum, and are secured by all of
the assets of the Company. The notes also may be converted, at the option of the
Investors, into shares of common stock of the Company at a conversion price of
$0.20 per share. The conversion price is subject to adjustment based on certain
conditions of the Security Purchase Agreement. The Company may require
conversion of the Notes if the Company raises $3 million in public or private
equity offerings, at a price equal to or greater than $0.30 per share of common
stock, within 12 months of the date of issuance of the Notes. In connection with
the issuance of the Notes, the Company also issued warrants to purchase common
stock at a price of $0.40 per share (subject to adjustment upon certain
conditions pursuant to the terms of the Security Purchase Agreement). The
warrants are exercisable for a period of 42 months from the date of
issuance.
 
 $500,000
of the $2,750,000 convertible notes were issued to a significant shareholder.
$750,000 of the $2,750,000 convertible notes were issued to a company that
appointed a member of our board of directors.
 
 The
$2,750,000 proceeds from the convertible notes payable were allocated between
the convertible debt and the warrants based on the relative fair value method
with $825,000 being allocated to the warrants as a debt discount and the
remainder of $1,925,000 being allocated to the convertible notes. The $825,000
warrant value was recorded as a debt discount and is being amortized over the
twelve month term of the note.
 
 The
conversion price of $0.20 was less than the fair market value of the stock of
$0.40 on the date the convertible notes were issued, creating a beneficial
conversion feature. Since the beneficial conversion feature was greater than the
$1,925,000 allocated fair value of the convertible notes, the entire allocated
amount of the convertible notes payable was recorded as beneficial conversion
feature. Since the notes are convertible immediately, the entire $1,925,000
beneficial conversion feature was immediately recorded as interest
expense.
 
 7
 **6.
Conversion of Related Party Notes Payable**
 
 In March
2005, a significant stockholder converted notes payable of $500,000 and related
accrued interest of $16,659, into 1,291,650 shares of the Company’s common stock
at $0.40 per share.
 
 **7.
Interest Expense**
 
 As Noted
in note 5, the Company recorded interest expense of $1,925,000 during the
quarter ended March 31, 2005 as a result of the beneficial conversion feature of
the convertible notes payable.
 
 **ITEM
2:MANAGEMENT'S DISCUSSION AND ANALYSIS OF**
 **FINANCIAL
CONDITION AND RESULTS OF OPERATIONS**
 
 In this
report references to "Viking," "we," "us," and "our" refer to Viking Systems,
Inc.
 
 **Overview**
 
 Viking
Systems, Inc. (“Viking” or “Viking Systems”) provides high performance 3D
endoscopic vision systems to hospitals for minimally invasive surgery. Viking
intends to leverage that position to become a market leader in bringing
integrated solutions to the digital surgical environment. We intend to develop a
portfolio of targeted medical technologies and services that serve the current
and emerging needs of the digital healthcare network. Our focus is to deliver
integrated information, visualization, and control solutions to the surgical
team, enhancing their capability and performance in minimally invasive surgery
(MIS) and complex surgical procedures.
 
  Discussion
of our financial results relative to the quarter ending March 31, 2004 does not
provide a meaningful analysis as the operations under new management and
business plan commenced in the second quarter of 2004. Our current results are
best understood in the context of our objectives and results during the balance
of 2004. During 2004 our mission consisted of making the following substantial
investments in the Company’s products, marketing programs, infrastructure and
personnel:
  ·
    In
      April, Viking purchased the assets of Vista Medical Technologies, Inc.’s
      proprietary 3D surgical visualization
business.
 
 ·
    New
      high resolution 2D cameras were introduced in the first half of 2004 to
      the Company’s key Original Equipment Manufacturers (“OEM”) accounts,
      underscoring our continuing commitment to the OEM business which remained
      at historical revenue levels.
 
 8
 ·
    Substantial
      investment was made in the upgrade, redevelopment, expansion and
      re-branding of the 3Di Digital Vision product line from April through
      October 2004, after suspending active selling of the systems product post
      acquisition.
 
 ·
    Significant
      marketing expenses were incurred for the re-launch of the 3Di Digital
      Vision System at the American College of Surgeons Conference in October
      2004.
 
 ·
    Senior
      sales management and regional sales managers were recruited to launch the
      sales of our new 3Di Digital Vision Systems in the second half of 2004.
 
 In the
first quarter of 2005, we continued the progress begun in 2004 with investment
in sales personnel, training, equipment and marketing programs. Our strategy is
to build our revenue base with our EndoSite 3Di Vision System and OEM camera
products. We believe our investments in our products, technology, new markets
and organization in 2004 will generate a substantial improvement in our
operations in late 2005 and 2006. Our improvements in the technology and focus
on the commercialization of this technology are expected to produce better
results than achieved historically by this business under Vista.
 
 Viking is
also the strategic visualization supplier to several leading procedure-specific
medical device manufacturers such as Aesculap and Richard Wolf. The Company
provides high resolution 2D cameras to its OEM customers. As the procedural
business of its partners and customers continues to shift to minimally invasive
techniques, Viking will introduce new products, services and capabilities to
respond to this important business segment. Viking is committed to the growth of
its OEM business and believes its engineering capabilities and advanced
technologies make it an ideal partner of choice.
 
 **Critical
Accounting Policies**
 
 This
Management’s Discussion and Analysis of Financial Condition and Results of
Operations discusses the Company’s Financial Statements, which have been
prepared in accordance with U.S. generally accepted accounting
principles.
 
 We
commenced operations in the medical device business during 2004. The preparation
of our financial statements requires management to make estimates and
assumptions that affect reported amounts of assets and liabilities and the
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. On an ongoing basis, management evaluates its estimates and
assumptions, including those related to receivables, inventory, income taxes,
accrued expenses, and revenue recognition. We anticipate that management will
base its estimates and judgments on historical experience and on various other
factors that are believed to be reasonable under the circumstances, the results
of which form the basis for making judgments about the carrying value of assets
and liabilities that are not readily apparent from other sources. Actual results
may differ from these estimates under different assumptions or conditions.
 
 9
 Management
believes the following critical accounting policies, among others, will affect
its more significant judgments and estimates used in the preparation of our
financial statements.
 
 **Inventory.** ****** The
Company reduces the stated value of its inventory for obsolescence or impairment
in an amount equal to the difference between the cost of the inventory and the
estimated market value, based upon assumptions about future demand and market
conditions. If actual future demand or market conditions are less favorable than
those projected by management, additional reductions in stated value may be
required.
 
 **Income
Taxes.** In
determining the carrying value of the Company’s net deferred tax assets, the
Company must assess the likelihood of sufficient future taxable income in
certain tax jurisdictions, based on estimates and assumptions, to realize the
benefit of these assets. If these estimates and assumptions change in the
future, the Company may record a reduction in the valuation allowance, resulting
in an income tax benefit in the Company’s Statements of Operations. Management
evaluates the realizability of the deferred tax assets and assesses the
valuation allowance quarterly.
 
 **Long-Lived
Asset Valuations.** ******  The
Company reviews long-lived assets such as property, equipment and definite-lived
intangibles for impairment whenever events or changes in circumstances indicate
that the carrying value of an asset may not be recoverable. As required by SFAS
No. 144, the Company uses an estimate of the future undiscounted net cash flows
of the related asset or group of assets over their remaining economic useful
lives in measuring whether the assets are recoverable. If the carrying amount of
an asset exceeds its estimated future cash flows, an impairment charge is
recognized for the amount by which the carrying amount exceeds the estimated
fair value of the asset. Impairment of long-lived assets is assessed at the
lowest levels for which there are identifiable cash flows that are independent
of other groups of assets. Assets to be disposed of are reported at the lower of
the carrying amount or fair value, less the estimated costs to sell. In
addition, depreciation of the asset ceases.
 
 **Revenue
Recognition.**  The
Company's revenues are derived from the sale of surgical visualization
technology products to end users, distributors and original equipment
manufactures. Revenue from the sale of products is recognized when a purchase
order has been received, the system has been shipped, the selling price is fixed
or determinable, and collection is reasonable assured. Most system sales are
F.O.B. shipping point, therefore shipment is deemed to have occurred when the
product is delivered to the transportation carrier. Most of the Company's sales
through March 31, 2005, have been for products that did not include installation
services. If installation is included as part of the contract, revenue is not
recognized until installation has occurred, or until any remaining installation
obligation is deemed to be perfunctory. Some sales of systems may include
training as part of the sale. In such cases, the portion of the revenue related
to the training, calculated based on the amount that would be charged for
training on a stand-alone basis, is deferred and recognized when the training
has been provided. The sales of products do not require specific customer
acceptance provisions and do not include the right of return except in cases
where the product does not function as guaranteed by the Company. The Company
provides a reserve allowance for estimated returns. To date, returns have not
been significant. Shipping and handling costs are included in cost of
sales.
 
 10
 **Stock-Based
Compensation.** ****** The
Company accounts for its employee stock-based compensation plans using the
intrinsic value method, as prescribed by APB Opinion No. 25, Accounting for
Stock Issued to Employees, and related interpretations. Accordingly, the Company
records deferred compensation costs related to its employee stock options when
the current market price of the underlying stock exceeds the exercise price of
each stock option on the measurement date (usually the date of grant). The
Company records and measures deferred compensation for stock options granted to
non-employees, other than members of the Company's Board of Directors, using the
fair value based method. Deferred compensation is expensed on a straight-line
basis over the vesting period of the related stock option. During the three
months ended March 31, 2005 and 2004, the Company did not grant any stock
options to employees or members of the Company's Board of Directors with
exercise prices below the market price on the measurement date.
 
 An
alternative method to the intrinsic value method of accounting for stock-based
compensation is the fair value based method prescribed by Statement of Financial
Accounting Standards (SFAS) No. 123, "Accounting for Stock-Based Compensation,"
as amended by SFAS No. 148, "Accounting for Stock-Based Compensation -
Transition and Disclosure." If the Company used the fair value based method, the
Company would be required to record deferred compensation based on the fair
value of the stock option at the date of grant as computed using an
option-pricing model, such as the Black-Scholes option pricing model. The
deferred compensation calculated under the fair value based method would then be
amortized over the vesting period of the stock option.
 
 **RESULTS
OF OPERATIONS**
 
 In
December 2002 we discontinued our previous operations. As described above, we
are now engaged in the medical device market. Our first acquisition was
completed during the quarter ended June 30, 2004.
 
 **Three-Month
Period Ended March 31, 2005 Compared to the Three-Month Period Ended March 31,
2004**
 
 *Revenues.* As
described in the Overview above, during the quarter ended March 31, 2004, we had
no revenue generating operations. In April 2004, we acquired assets and
operations related to our 3D endoscopic vision systems. For the quarter ended
March 31, 2005, we had product sales $876,403 compared to no sales for the
quarter ended March 31, 2004. The increase in revenues was due to a full quarter
of product sales from our Vision Systems Group, which we acquired in April 2004.
Sales to individual customers exceeding 10% or more of revenues in the quarter
ended March 31, 2005 were to three customers who accounted for 25%, 24% and 17%
of revenues, respectively.
 
 *Gross
Margins.* We had
gross margins of $257,178 or 29.4% for the quarter ended March 31, 2005 and
gross margins of $0 for the quarter ended March 31, 2004. The increase in gross
margin during 2005 was due to the 3Di System and OEM product sales during the
quarter ended March 31, 2005 compared to no sales during the quarter ended March
31, 2004. We expect our gross margins to improve as we increase our 3Di product
sales.
 
 11
 *Sales
and Marketing Expenses.* Sales
and Marketing expenses were $473,816 for the quarter ended March 31, 2005 and $0
for the quarter ended March 31, 2004. The increase in operating expenses was due
to the restart of operations. We expect that our sales and marketing expenses
will remain at this level as we establish our 3Di Systems business.
 
 *Research
and Development Expenses.* Research
and Development expenses were $-191,376 for the quarter ended March 31, 2005 and
$0 for the quarter ended March 31, 2004. The increase is due to the acquisition
of the Visualization business during the second quarter of 2004. We expect that
our research and development expenses will remain at their current levels as we
continue to develop, maintain and support our current products.
 
 *General
and Administrative Expenses.* We had
General and Administrative expenses of $491,767 for the quarter ended March 31,
2005 and $111,676 for the quarter ended March 31, 2004, representing an increase
of $380,091. The increase in general and administrative expense in 2005 was due
to the acquisition of the visualization business during the second quarter of
2004. Our general and administrative expenses for the three months ended March
31, 2005 consisted primarily of the following:
 
 ·
    $157,640
      in payroll and fringe benefits,
 
 ·
    $147,782
      in legal expenses, including $115,000 in closing costs and legal fees
      related to Convertible Notes Payable,
 
 ·
    $24,933
      in audit expenses,
 
 ·
    $40,455
      in consulting expenses,
 
 ·
    $50,422
      in royalty and license fees,
 
 ·
    $49,570
      in insurance expenses,
 
 *Net
Income (Loss).* We had a
net loss of $2,848,578 for the quarter ended March 31, 2005 and a net loss of
$111,676 for the quarter ended March 31, 2004, representing an increase of
$2,736,905. The increase in net loss for the first quarter was due the
acquisition of the visualization business during the second quarter of 2004. We
also incurred significant costs implementing our sales and marketing plan,
developing and improving our 3Di products line, and maintaining operations of
the Visualization business. We also incurred $1,925,000 in non-cash interest
expense and $115,000 in legal fees related to the Convertible Notes. Our net
loss for the quarter ended March 31, 2005 was the result of us having revenues
of $876,403, costs of sales of $619,225, operating expenses $1,156,959 and
interest expense of $1,948,797.
 
 12
 **LIQUIDITY
AND CAPITAL RESOURCES**
 
 We have
financed our operations principally through private sales of equity securities
and convertible notes. From January 1, 2004 through March 31, 2005, we have
raised net proceeds of $900,000 through the sale of common and preferred stock
in private placements, and $3,300,000 through the issuance of convertible
promissory notes. As of March 31, 2005, we had cash, cash equivalents and
short-term investments of $1,013,252 compared to $139,393 as of December 31,
2004.
 
 During
the quarter ended March 31, 2005, we raised $2,750,000 through the issuance of
convertible notes (the “Notes”). The Notes mature 12 months from the date of
issuance, accrue interest at 10% per annum, and are secured by all of our
assets. The notes also may be converted, at the option of the Investors, into
shares of our common stock at a conversion price of $0.20 per share. The
conversion price is subject to adjustment based on certain conditions of the
Security Purchase Agreement. We may require conversion of the Notes if we raise
$3 million in public or private equity offerings, at a price equal to or greater
than $0.30 per share of common stock, within 3 months of the date of issuance of
the Notes. In connection with the issuance of the Notes, we also issued warrants
to purchase common stock at a price of $0.40 per share (subject to adjustment
upon certain conditions pursuant to the terms of the Security Purchase
Agreement). The warrants are exercisable for a period of 42 months from the date
of issuance.
 
 Net cash
used in operating activities was $2,237,959 **** and
$66,718 during the quarters ended March 31, 2005 and March 31, 2004,
respectively. The increase in net cash used in operating activities during 2005
compared to 2004 was attributable to the acquisition of the Vision Systems Group
in April 2004 and the development of our EndoSite 3Di product line and sales and
marketing organization.
 
 Net cash
used in investing activities was $41,006 and $6,832 during the quarters ended
March 31, 2005 and March 31, 2004, respectively. The increase in cash used in
investing activities in 2005 was attributable to increased purchases of
equipment needed for demonstration equipment of our new 3Di product
line.
 
 Cash flow
provided by financing activities was $3,152,824 and $400,000 during the quarters
ended March 31, 2005 and March 31, 2004, respectively. The cash flows from
financing activities in 2005 were attributable to proceeds from a private
placement of secured convertible notes in the amount of $2,750,000, proceeds
received from short-term bank borrowings of $302,824, and proceeds from related
party notes payable of $100,000.
 
 We
incurred operating losses in 2005 and 2004, and at March 31, 2005, had an
accumulated deficit of approximately $5,164,000. At March 31, 2005, we had cash
of $1,013,252.
 
 13
 In
January 2005, we received a $200,000 line of credit from Silicon Valley Bank. In
February and March 2005, we received $2,750,000 from the issuance of convertible
notes payable. In addition, we have amounts available under a bank line of
credit facility equal to 80% of our outstanding receivables up to a maximum of
$400,000, which expires in September 2005 and is subject to annual renewals.
 
 We
believe that in order to continue our operations, development of our products,
and implementation of our business plan, we will need additional financing. We
are pursuing additional financing through a private placement offering of our
common stock in which we are attempting to raise approximately $3 million during
2005. Additionally, we are continuing our efforts to increase revenues by
obtaining new customers and to minimize our operating costs. There can be no
assurance that we will be successful in obtaining financing or in our efforts to
increase revenues and decrease operating costs. If we are unable to obtain
additional financing, we may be required to reduce operations, reduce or
discontinue further research and development, and/or reduce or eliminate further
acquisition activities.
 
 **Off-Balance
Sheet Arrangements.** Off-balance
sheet arrangements, as defined by SEC, include certain transactions, agreements,
or other contractual arrangements pursuant to which a company has any obligation
under certain guarantee contracts, certain retained or contingent interests in
assets transferred to an unconsolidated entity, any obligation under certain
derivative investments, or any obligation under a material variable interest in
an unconsolidated entity that provides financing, liquidity, market risk or
credit risk support or engages in leasing, hedging or research and development
services with us. See Note 11 of the Notes to Consolidated Financial Statements
contained in our annual report on Form 10-KSB for the fiscal year ended December
31, 2004.
 
 **Forward
Outlook and Risks**
 
 This Form
10-QSB contains and incorporates by reference certain “forward-looking
statements” within the meaning of Section 27A of the Securities Act and Section
21E of the Exchange Act with respect to results of our operations and
businesses. All statements, other than statements of historical facts, included
in this Form 10-KSB, including those regarding market trends, our financial
position, business strategy, projected costs, and plans and objectives of
management for future operations, are forward-looking statements. In general,
such statements are identified by the use of forward- looking words or phrases
including, but not limited to, “intended,” “will,” “should,” “may,” “expects,”
“expected,” “anticipates,” and “anticipated” or the negative thereof or
variations thereon or similar terminology. These forward-looking statements are
based on our current expectations. Although we believe that the expectations
reflected in such forward-looking statements are reasonable, there can be no
assurance that such expectations will prove to be correct. Because
forward-looking statements involve risks and uncertainties, our actual results
could differ materially. Important factors that could cause actual results to
differ materially from our expectations are disclosed hereunder and elsewhere in
this Form 10-KSB. These forward-looking statements represent our judgment as of
the date of this Form 10-KSB. All subsequent written and oral forward-looking
statements attributable to Viking are expressly qualified in their entirety by
the Cautionary Statements. We disclaim, however, any intent or obligation to
update our forward-looking statements.
 14
 
 ***Operating
History.*** We were
inactive in 2002 and 2003. We commenced active operations by acquiring assets
from Vista Potential investors should be aware that there is only a limited
basis upon which to evaluate our prospects for achieving our intended business
objectives. We have limited resources and have had limited revenues since our
formation.
 
 ***Possibility
of Total Loss of Investment.*** An
investment in the Company is an extremely high risk investment, and should not
be made unless the investor has no need for current income from the invested
funds and unless the investor can afford a total loss of his or her investment.
 
 ***Additional
Financing Requirements.*** We will
likely be required to seek additional financing in order to fund our operations
and carry out our business plan. In order to fund our operations and effect
additional acquisitions, we will be required to obtained additional capital.
There can be no assurance that such financing will be available on acceptable
terms, or at all. We do not have any arrangements with any bank or financial
institution to secure additional financing and there can be no assurance that
any such arrangement, if required or otherwise sought, would be available on
terms deemed to be commercially acceptable and in our best
interests.
 
 ***No
Public Market for Securities*** . There
is no public market for our common stock and we can give no assurance that an
active market will develop, or if developed, that it will be sustained.
 
 ***Auditor’s
Opinion has a Going Concern Qualification*** . Our
auditor’s report dated January 28, 2005 for the year ended December 31, 2004,
included a going concern qualification which stated that our significant
operating losses raise substantial doubt about our ability to continue as a
going concern.
 
 ***No
Appraisal of Vista Assets.*** We did
not obtain an independent appraisal or valuation of the assets and operations we
acquired from Vista.
 
 ***We
do not anticipate paying any dividends and any gains from your investment in our
stock will have to come from increases in the price of such
stock.*** **** We
currently intend to retain any future earnings for use in our business and do
not anticipate paying any cash dividends in the foreseeable future.
 
 **Medical
Operations Risks**
 
 We
acquired assets and operations from Vista as described in Item 1 above. We also
intend to attempt to acquire additional medical products and operations from
time to time as opportunities become available. Our operations in the medical
product industry will subject us to various risks which include, but are not
limited, to the following:
 
 15
 ***We
Operate in a Competitive Market.*** The
market for medical products and services is competitive and new offerings and
technologies are becoming available regularly. We cannot guarantee that we
will compete successfully against our potential competitors, especially those
with significantly greater financial resources or brand name
recognition.
 
 ***If
We Fail to Retain Key Personnel and Hire, Train and Retain Additional Qualified
and Experienced Employees, We May Not Be Able to Compete
Effectively.*** **** Our
future success will depend to a large extent on retaining our employees and
recruiting sufficient qualified employees to fill vacancies created by attrition
or expansion of our operations.  There is likely to be a competitive labor
market for such staff and there is no assurance that we will be able to attract
and retain an adequate number of suitable employees.
 
 ***We
Are Subject To Significant Domestic and International Regulation and May Not Be
Able To Obtain Necessary Regulatory Clearances to Sell Our Products.*** **** We sell
medical devices **.** The
manufacture and sale of medical devices intended for commercial distribution are
subject to extensive governmental regulation.  Our failure to comply with
regulatory requirements would jeopardize our ability to market our
products.  Noncompliance with applicable requirements can result in failure
of the regulatory agency to grant pre-market clearance or approval for devices,
withdrawal or suspension of approval, total or partial suspension of production,
fines, injunctions, civil penalties, refunds, recall or seizure of products and
criminal prosecution. Medical devices are regulated in the United States
primarily by the FDA and, to a lesser extent, by state agencies.  Sales of
medical device products outside the United States are subject to foreign
regulatory requirements that vary from country to country.  Generally,
medical devices require pre-market clearance or pre-market approval prior to
commercial distribution.  A determination that information available on the
medical device is not sufficient to grant the needed clearance or approval will
delay market introduction of the product.  In addition, material changes or
modifications to, and changes in intended use of, medical devices also are
subject to FDA review and clearance or approval.  The FDA regulates the
research, testing, manufacture, safety, effectiveness, labeling, storage, record
keeping, promotion and distribution of medical devices in the United States and
the export of unapproved medical devices from the United States to other
countries.  The time required to obtain approvals required by foreign
countries may be longer or shorter than that required for FDA clearance, and
requirements for licensing may differ from FDA requirements.  The current
regulatory environment in Europe for medical devices differs significantly from
that in the United States.
 
 ***We
Expect to Encounter Rapid Technological Change and Significant Competition.*** The
medical device market in which we compete is characterized by intensive
development efforts and rapidly advancing technology.  Our future success
will depend, in large part, upon our ability to anticipate and keep pace with
advancing technology and competing innovations.  We may not be successful
in identifying, developing and marketing new products or enhancing our existing
products. We believe that a number of large companies, with significantly
greater financial, manufacturing, marketing, distribution and technical
resources and experience than ours, are focusing on the development of
visualization products for minimally invasive microsurgery.
 
 16
 ***Our
Profitability is Directly Related to the Level Of Reimbursements for Surgical
Procedures Using the Offered Products.*** Our
profitability will be directly related to the level of payments for the surgical
procedures, in which our products will be involved, either by Medicare or
private insurance companies.  We could be adversely affected by changes in
payment policies of government or private health care payors, particularly to
the extent any such changes affect payment for the procedure in which our
products are intended to be used.  It is a continuing trend in U.S. health
care for such payments to be under continual scrutiny and downward
pressure.  We believe that reimbursement in the future will be subject to
increased restrictions, both in the United States and in foreign markets and
that the overall escalating cost of medical products and services has led to and
will continue to lead to increased pressures on the health care industry, both
foreign and domestic, to reduce the cost of products and services, including
products which we offer.
 
 We expect
that our products typically will be used by hospitals and surgical centers,
which bill various third-party payors, such as governmental programs and private
insurance plans, for the health care services provided to their patients. 
Third-party payors carefully review and increasingly challenge the prices
charged for medical products and services or negotiate a flat rate fee in
advance.  Payment rates from private companies also vary depending on the
procedure performed, the third-party payor, the insurance plan and other
factors.  Medicare compensates hospitals at a predetermined fixed amount
for the costs associated with an in-patient hospitalization based on the
patient’s discharge diagnosis and compensates physicians at a pre-determined
fixed amount based on the procedure performed, regardless of the actual costs
incurred by the hospital or physician in furnishing the care and unrelated to
the specific devices or systems used in that procedure.  Medicare and other
third-party payors are increasingly scrutinizing whether to cover new products
and the level of payment for new procedures.  The flat fee reimbursement
trend is causing hospitals to control costs strictly in the context of a managed
care system in which health care providers contract to provide comprehensive
health care for a fixed cost per person.  We are unable to predict what
changes will be made in the reimbursement methods utilized by such third-party
payors.
 
 If we
obtain the necessary foreign regulatory registrations or approvals, market
acceptance of our products in international markets would be dependent, in part,
upon the acceptance by the prevailing health care financing system in each
country.  Health care financing systems in international markets vary
significantly by country and include both government sponsored health care
programs and private insurance.  We cannot assure you that these financing
systems will endorse the use of our products.
 
 ***We
May Be Subject To Product Liability Claims And Have Limited Insurance
Coverage.*** **** By
engaging in the medical devices business, we will face an inherent and
significant business risk of exposure to product liability claims in the event
that the use of our products results in personal injury or death.  Also, in
the event that any of our products proves to be defective, we may be required to
recall or redesign such products. We will need to maintain adequate product
liability insurance coverage.  If we are able to maintain insurance, of
which there can be no assurance, our coverage limits may not be adequate to
protect us from any liabilities we might incur in connection with the
development, manufacture and sale of our products.  Product liability
insurance is expensive and in the future may not be available to us on
acceptable terms, if at all.  A successful product liability claim or
series of claims brought against us in excess of our insurance coverage or a
product recall would negatively impact our business.
 
 17
 **ITEM
3. CONTROLS AND PROCEDURES**
 **EVALUATION
OF DISCLOSURE CONTROLS AND PROCEDURES**
 
 (a)
    Evaluation
      of Disclosure Controls and Procedures
 
 Under the
supervision and with the participation of our management, including our Chief
Executive Officer and Chief Financial Officer, we evaluated the effectiveness of
the design and operation of our disclosure controls and procedures as of March
31, 2005 (as defined in Rule 13a-15(e) or 15d-15(e) under the Securities
Exchange Act of 1934 (the "Exchange Act")). In connection with this evaluation,
management identified a deficiency that existed in the design or operation or
our internal control over financial reporting that it considers to be “material
weaknesses.” The Public Company Accounting Oversight Board has defined a
material weakness as a “significant deficiency or combination of significant
deficiencies that results in more than a remote likelihood that a material
misstatement of the annual or interim financial statements will not be prevented
or detected.”
 
 The
deficiency in our internal control related to accounting for the debt discount
resulting from the warrants issued in connection with the convertible notes and
the related beneficial conversion feature. The adjustment to record the debt
discount and beneficial conversion feature was detected and has been
appropriately recorded and disclosed in this Form 10-QSB. We are in the process
of improving our internal control over financial reporting in an effort to
remediate this deficiency.
 
 Based
upon that evaluation and the deficiency identified above, the Chief Executive
Officer and Chief Financial Officer concluded that, as of the end of the period
covered by this report, our disclosure controls and procedures were not
effective in timely alerting them to the material information relating to us (or
our consolidated subsidiaries) required to be included in the reports we file or
submit under the Exchange Act.
 
 (b)  Changes in
Internal Controls
 
 During
the fiscal quarter covered by this report, there has been no change in our
internal control over financial reporting (as defined in Rule 13a-15(f) or
15d-15(f) under the Exchange Act) that has materially affected, or is reasonably
likely to materially affect, our internal control over financial
reporting.
 
  18
  **PART
II - OTHER INFORMATION**
 
 Item
1.  Legal
Proceedings . We are
not a party to any legal proceeding.
 
 Item
2.  Unregistered
Sales of Equity Securities and Use of Proceeds
 
 Shares
Issued in Unregistered Transactions
 
 We issued
shares of our common stock in unregistered transactions from 1998 through 2005.
Except for the shares issued in 2000, all of the following shares of common
stock issued were in non registered transactions in reliance on Section 4 (2) of
the Securities Act of 1933, as amended (the “Securities Act”). The shares issued
in 2000 were issued pursuant to rule 504 of Regulation D promulgated under the
Securities Act of 1933, as amended. The shares of common stock issued were as
follows:
 
 **Issuance
of Preferred Stock**
 
 On
December 18, 2003, we granted Donald Tucker, the Company’s largest shareholder,
an option to purchase 5,000,000 shares of our Series A Preferred Stock for
$400,000. Each share of Series A Preferred Stock was convertible into four
shares of our common stock. Mr. Tucker subsequently exercised his option and
purchased all 5,000,000 shares of Series A Preferred Stock. In December 2004, he
converted his 5,000,000 shares of Series A Preferred Stock into 20,000,000
shares of our common stock.
 
 **Loan
Transactions**
 
 Donald
Tucker made several loans to the Company during 2004 and during the first
quarter of 2005. Each of such loans was unsecured and was convertible into
shares of our common stock or other debt securities. Information about such
loans is as follows:
 
 Date
      of Loan
    Amount
    Interest
      Rate
    Maturity
      Date
    Conversion
      Rate10/26/04
    $200,000
    10%
    3/31/05
    $.40
      per share(1)12/6/04
    $200,000
    10%
    3/31/05
    $.40
      per share(1)1/12/05
    $
      50,000
    10%
    3/31/05
    $.40
      per share(1)1/21/05
    $
      50,000
    10%
    3/31/05
    $.40
      per share(1)2/5/05
    $500,000
    10%
    3/31/05
    (2)
 
 (1) On March
22, 2005, the principal balance of these loans, together with accrued interest
thereon, was converted into a total of 1,291,650 shares of our common
stock.
 
 (2) On
March 22, 2005, this loan was converted into another debt instrument. On that
date Viking entered into a Securities Purchase Agreement and related agreements
(the "Transaction Documents"), among (i) Viking, (ii) St. Cloud Capital
Partners, L.P., a Delaware limited partnership ("St. Cloud"), as "Lead Lender"
and "Collateral Agent" and (iii) St. Cloud, Donald Tucker, Brian Miller, and any
other person signing the signature page of the Securities Purchase Agreement as
an Investor or that becomes an Investor after March 22, 2005, (collectively, the
"Investors"). Pursuant to the Securities Purchase Agreement, Viking has sold and
will sell promissory notes ("Notes") to Investors in the maximum aggregate
amount of $2,750,000. One of such Investors was Donald F. Tucker who converted
his February 5, 2005 loan into a $500,000 loan sold pursuant to the Securities
Purchase Agreement. The material terms of the Securities Purchase Agreement and
other Transaction Documents are set forth in the Management’s Discussion and
Analysis Section of this our annual report filed on Form 10-KSB for year ended
December 31, 2004.
 
 19
 Marshall
Geller, a recently appointed director of Viking, is an affiliate of St. Cloud
Capital Partners. St. Cloud purchased a note in the above-described transaction
in the amount of $750,000. Such Note is convertible into 3,750,000 shares of
Viking common stock. Pursuant to the terms of the Securities Purchase Agreement,
St. Cloud was issued a warrant to purchase 937,500 shares of Viking’s common
stock.
 
 All
purchasers represented in writing or orally that they acquired the securities
for their own accounts. A resale legend has been provided for the stock
certificates stating that the securities have not been registered under the
Securities Act of 1933 and cannot be resold or otherwise transferred without
registration or an exemption (such as that provided by rule 144).
 
 No sales
of securities, registered or unregistered, have been undertaken by the company
other than the issuances described above.
 
 Item
3.  Defaults
by the Company on its Senior Securities .
None
 
 Item
4.  Submission
of Matters to Vote of Security Holders .
None
 
 Item
5.  Other
Information .
 
 **Loan
Guarantee Collateral**
 
 On
January 27, 2005, we entered into a Loan and Security Agreement with Silicon
Valley Bank. The Loan Agreement provides for a maximum borrowing of $200,000.
The loan is secured by the assets of the Company. The loan is also secured by a
$200,000 certificate of deposit owned by Donald Tucker. In April 2005 this Loan
and Security Agreement with Silicon Valley Bank was reduced to
$100,000.
 
 Item
      6. Exhibits.
    31.1
      Certification by the Chief Executive Officer pursuant to Section 302 of
      the Sarbanes-Oxley Act of 2002.31.2
      Certification by the Chief Financial Officer pursuant to Section 302 of
      the Sarbanes-Oxley Act of 2002.32.1
      Certification by the Chief Executive Officer pursuant to Section 906 of
      the Sarbanes-Oxley Act of 2002.32.2
      Certification by the Chief Financial Officer pursuant to Section 906 of
      the Sarbanes-Oxley Act of 2002.
 
 20
 SIGNATURE
 
 In
accordance with the requirements of the Exchange Act, the Company has caused
this report to be signed on its behalf by the undersigned thereunto duly
authorized.
 
 Dated:
      May 13, 2005
    VIKING
      SYSTEMS, INC.By/s/
      Thomas B. MarshChief
      Executive Officer, PresidentBy/s/
      Joseph WarrinoChief
      Financial Officer
 
 
  21