**U.S. SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

**Form 10-K**
| **(Mark One)** | ** **                                                                                          |
|----------------|-----------------------------------------------------------------------------------------------------|
| x              | **ANNUAL REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**For the fiscal year ended March 31, 2006**
| o | ** ** | **TRANSITION REPORT UNDER SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|---|------------|---------------------------------------------------------------------------------------------------|

 

**For the transition periodfrom                      to**

**CommissionFile No. 0-28034**

**CardioTech International, Inc.**

(Name of small businessissuer in its charter)

| **Massachusetts**                                  | ** ** | **04-3186647**                        |
|----------------------------------------------------|------------|---------------------------------------|
| (State or other  jurisdiction of                   |       | (I.R.S. Employer  Identification No.) |
| incorporation or  organization)                    |       |                                  |
|                                               |       |                                  |
| **229  Andover Street, Wilmington, Massachusetts** | ** ** | **01887**                             |
| (Address of  principal executive offices)          |       | (Zip Code)                            |
|                                               |       |                                  |

 

Issuer’s telephone number:**(978) 657-0075**

Securities registeredunder Section 12(b) of the Exchange Act:

| Title of each class                         |   | Name of each  exchange on which registered |
|---------------------------------------------|--------|--------------------------------------------|
| **Common  Stock, $.01 par value per share** |   | **American  Stock Exchange**               |

 

**Securitiesregistered pursuant to Section 12(g) of the Act: None**

Indicateby check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405of the Securities Act.   Yes x  No o

Indicateby check mark if the registrant is not required to file reports pursuant to Section 13or Section 15(d) of the Act.   Yes o   Nox

Indicatewhether the registrant (1) filed all reports required to be filed by Section 13or 15(d) of the Exchange Act during the past 12 months (or for suchshorter period that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days. Yes x  No o

Indicateby check mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained in this herein, and will be contained, to thebest of registrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or anyamendment to this Form 10-K. o

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer. Or a non-accelerated filer (as defined in Rule 12b-2of the Act):

| o  Large Accelerated Filer |   | o  Accelerated Filer |   | x  Non-Accelerated Filer |
|----------------------------|--------|----------------------|--------|--------------------------|

 

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

As of June 23, 2006, 19,832,683 shares of theregistrant’s Common Stock were outstanding, and the aggregate market value ofthe registrant’s Common Stock held by non-affiliates of the registrant (withoutadmitting that such person whose shares are not included in such calculation isan affiliate) was approximately $40,417,000 based on the last sale price asreported by the American Stock Exchange on such date.

 

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**CARDIOTECHINTERNATIONAL, INC.FORM 10-KFOR THE YEAR ENDED MARCH 31, 2006**

**INDEX**
| **PART I**   | ** ** | ** **                                                                            | ** ** | ** ** | ** ** |
|-------------------|------------|---------------------------------------------------------------------------------------|------------|------------|------------|
| Item 1.           |       | Description of Business                                                               |       | 1          |       |
| Item  1A.         |       | Risk  Factors                                                                         |       | 11         |       |
| Item 1B.          |       | Unresolved Staff Comments                                                             |       | 22         |       |
| Item 2.           |       | Description of Properties                                                             |       | 22         |       |
| Item  3.          |       | Legal  Proceedings                                                                    |       | 22         |       |
| Item 4.           |       | Submission of Matters to a Vote of Security Holders                                   |       | 22         |       |
| ** **        | ** ** | ** **                                                                            | ** ** | ** ** | ** ** |
| **PART II**  | ** ** | ** **                                                                            | ** ** | ** ** | ** ** |
| Item 5.           |       | Market Information for Common Equity and Related  Stockholder Matters                 |       | 23         |       |
| Item 6.           |       | Selected Consolidated Financial Data                                                  |       | 25         |       |
| Item 7.           |       | Management’s Discussion and Analysis or Plan of  Operation                       |       | 26         |       |
| Item 7A.          |       | Quantitative and Qualitative Disclosures About Market  Risk                           |       | 33         |       |
| Item 8.           |       | Financial Statements                                                                  |       | 33         |       |
| Item 9.           |       | Changes In and Disagreements With Accountants on  Accounting and Financial Disclosure |       | 33         |       |
| Item 9A.          |       | Controls and Procedures                                                               |       | 33         |       |
| Item  9B.         |       | Information                                                                           |       | 33         |       |
| ** **        | ** ** | ** **                                                                            | ** ** | ** ** | ** ** |
| **PART III** | ** ** | ** **                                                                            | ** ** | ** ** | ** ** |
| Item 10.          |       | Directors and Executive Officers of the Registrant.                                   |       | 34         |       |
| Item 11.          |       | Executive Compensation                                                                |       | 36         |       |
| Item 12.          |       | Security Ownership of Certain Beneficial Owners and  Management                       |       | 39         |       |
| Item 13.          |       | Certain Relationships and Related Transactions                                        |       | 40         |       |
| Item 14.          |       | Principal Accounting Fees and Services                                                |       | 40         |       |
| ** **        | ** ** | ** **                                                                            | ** ** | ** ** | ** ** |
| **PART IV**  | ** ** | ** **                                                                            | ** ** | ** ** | ** ** |
| Item 15.          |       | Exhibits, Financial Statement Schedules and Reports on  Form 10-K                |       | 42         |       |
|              |       | Index to Financial  Statements                                                        |       | F-1        |       |

 

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**PART I**

**Item 1.**                       Descriptionof Business

**Forward-LookingStatements**

ThisAnnual Report on Form 10-K contains certain forward-lookingstatements that are based on current expectations. In light of the importantfactors that can materially affect results, including those set forth in thisparagraph and below, the inclusion of forward-looking information herein shouldnot be regarded as a representation by the Company or any other person that theobjectives or plans of the Company will be achieved. The Company may encountercompetitive, technological, financial and business challenges making it moredifficult than expected to continue to develop and market its products; themarket may not accept the Company’s existing and future products; the Companymay not be able to retain its customers; the Company may be unable to retainexisting key management personnel; and there may be other material adversechanges in the Company’s operations or business. Certain important factorsaffecting the forward-looking statements made herein include, but are notlimited to (i) continued downward pricing pressures in the Company’stargeted markets, (ii) the continued acquisition of the Company’scustomers by certain of its competitors, and (iii) continued periods ofnet losses, which could require the Company to find additional sources offinancing to fund operations, implement its financial and business strategies,meet anticipated capital expenditures and fund research and development costs. Assumptionsrelating to budgeting, marketing, product development and other managementdecisions are subjective in many respects and thus susceptible tointerpretations and periodic revisions based on actual experience and businessdevelopments, the impact of which may cause the Company to alter its marketing,capital expenditure or other budgets, which may in turn affect the Company’sfinancial position and results of operations. The reader is therefore cautionednot to place undue reliance on forward-looking statements contained herein,which speak solely as of the date of this Form 10-K. The Companyassumes no responsibility to update any forward-looking statements as a resultof new information, future events, or otherwise. For further information youare encouraged to review CardioTech’s filings with the Securities and ExchangeCommission, including its Quarterly Reports on Form 10-Q for theperiods ended June 30, 2005, September 30, 2005 and December 31,2005. The Company assumes no obligation to update the information contained inthis filing.

**General**

*History*

CardioTech International, Inc. (“CardioTech” orthe “Company”) was founded in 1993 as a subsidiary of PolyMedica Corporation (“PMI”).In June 1996, PMI distributed all of the shares of CardioTech’s commonstock, par value $.01 per share, that PMI owned, to PMI stockholders of record.The Company’s proprietary ChronoFlex polyurethane materials have been soldthrough its CT Biomaterials division since the formation of the Company asbiomaterials for the manufacture of medical devices. These premium biomaterialsare sold under the trade names: ChronoFlex, ChronoThane, HydroThane,ChronoFilm, HydroMed and Hydroslip, and are used by the Company’s customers foruse in both acute and chronically implanted devices such as stents, artificialhearts, and vascular ports.

The Company has one operating segment, medical devicemanufacturing and sales, and operates as three divisions;(i) biomaterials, (ii) private-label medical device manufacturing and(iii) cardiopulmonary products.

In July 1999, Dermaphylyx International, Inc.(“Dermaphylyx”) was formed by certain affiliates of CardioTech to developadvanced wound healing products. Dermaphylyx was merged into CardioTecheffective March 2004 and is now a wholly-owned subsidiary of CardioTech. InJune 2006, the Company’s Board of Directors decided to cease theoperations of Dermaphylyx, the costs of which are immaterial to the Company’soperations.

In April 2001, the Company acquired Catheter andDisposables Technology, Inc. (“CDT”). CDT is an original equipmentmanufacturer and supplier of private-label advanced disposable medical devicesfrom concept to finished packaged and sterilized products. Certain devicesdesigned, developed and manufactured for customers by CDT include sensing,balloon, and drug delivery catheters; disposable endoscopes; and in-vitrodiagnostic and surgical disposables.

In April 2003, the Company merged with GishBiomedical, Inc. (“Gish”). Gish manufacturers single use cardiopulmonarybypass products that have a disposable component.

In March 2004,CardioTech joined with Implant Sciences Corporation (“Implant”) to participatein the funding of CorNova. CorNova was formed to develop a novel coronary drugeluting stent using the combined capabilities and technology of CorNova,Implant Sciences and CardioTech. CardioTech currently has a 19% equity interestin the issued and outstanding common and preferred stock of CorNova. AlthoughCorNova is expected to incur operating losses for the next several quarters,the Company has no obligation to fund CorNova.

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*Technology and Intellectual Property*

CardioTech owns a number of patents relating to itsvascular graft manufacturing technology. In addition, PMI has granted toCardioTech an exclusive, perpetual, worldwide, royalty-free license for the useof one polyurethane patent and related technology in the field consisting ofthe development, manufacture and sale of implantable medical devices andbiodurable polymer material to third parties for the use in medicalapplications (the “Implantable Device and Materials Field”). PMI also owns,jointly with Thermedics, Inc., an unrelated company that manufactures medicalgrade polyurethane, the ChronoFlex polyurethane patents relating to theChronoFlex technology (“Joint Technology”). PMI has granted to CardioTech anon-exclusive, perpetual, worldwide, royalty-free sublicense of these patentsfor use in the Implantable Devices and Materials Field.

ChronoFilm is a registered trademark of PMI. ChronoFlexis a registered trademark of CardioTech. ChronoThane, ChronoPrene, HydroThane,PolyBlend and PolyWeld are tradenames of CardioTech. DuraGraft and CardioPassare trademarks of CardioTech.

*Research and Development*

The Company is currentlydeveloping new products that address annual worldwide markets exceeding $1billion. The CardioPass graft is the Company’s proprietary, synthetic coronaryartery bypass graft (“SynCAB”). The Company is developing the CardioPass graft,using specialized ChronoFlex polyurethane materials, to produce a syntheticgraft of 5mm in diameter specifically designed for use in coronary arterybypass graft (“CABG”) surgery. If successfully developed, the Company believesthat the SynCAB may be used initially to provide an alternative to patientswith insufficient or inadequate (“suboptimal”) native vessels for use in bypasssurgery as a result of repeat procedures, trauma, disease or other factors. TheCompany believes, however, that the CardioPass Graft may ultimately be used asa substitute for native saphenous veins, thus avoiding the trauma and expenseassociated with the surgical harvesting of the vein.

According to the 2004report of the American Heart Association, approximately 500,000 bypassoperations were performed in the U.S. in 2003. The Company estimates thatapproximately 750,000 CABG procedures were performed worldwide during the sameyear. The Company believes that approximately 20% of these CABG procedures wereperformed on patients who had previously undergone bypass surgery, and that thenumber of repeat procedures will continue to increase as a percentage ofprocedures performed. Currently, approximately 70% of CABG procedures areperformed utilizing the saphenous vein.

The Company conductedlimited clinical evaluations of the SynCAB graft in three (3) patients inBrazil. As of March 31, 2006, the Company believes all three patients havehad an uneventful post-operative course. The Company initiated plans in fiscal2006 to obtain European marketing approvals. In May 2006, the Companyreceived written acknowledgement from its Notified Body in Europe that itsclinical trial plan had been accepted. The planned 10 patient clinical trialprotocol allows surgeons to intraoperatively decide to use the SynCAB insteadof suboptimal autologous vessels. Patients will be followed for 90 days andassessed for graft patency and quality of life measures. Following the clinicaltrial, the analyzed data will be submitted by CardioTech to the Notified Bodyin support of its CE Mark application.

In January 2006,CardioTech made the strategic decision to apply for an Investigational DeviceExemption (“IDE”) in the U.S., while simultaneously pursuing the CE Mark. TheCompany has initiated discussions with thought-leaders in the cardiac surgicalfield for them to become Principal Investigators in a clinical trial. The clinicalend points will be patient survivability, quality of life, freedom from angina,and graft patency.

CardioPass is a Class III(highest risk) device that requires a Pre Market Approval (PMA) from the FDA. Forthis PMA, we must first obtain an IDE before we can begin clinical trials onhumans in the United States to determine the safety and efficacy of the graft. TheCompany plans to file an IDE in fiscal 2008.

In June 2006, theCompany announced that it signed an agreement to develop innovative medicalsolutions for the treatment of congestive heart failure. Development at theCompany’s Gish Biomedical rapid prototype laboratories will utilize proprietaryantithrombogenic Gish Biocompatible Surface (“GBS”) technology.

*Manufacturing Operations*

TheCompany generates approximately 91% of its product sales from manufacturingoperations at Gish and CDT.

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**MedicalBackground**

Bloodis pumped from the heart throughout the body via arteries. Blood is returned tothe heart at relatively low pressure via veins, which have thinner walls thanarteries and have check valves, which force blood to move in one direction. Becausea specific area of the body is often supplied by a single main artery, rupture,severe narrowing or occlusion of the artery supplying blood to that area islikely to cause an undesirable or catastrophic medical outcome.

Vasculargrafts are used to replace or bypass occluded, damaged, dilated or severelydiseased arteries and are sometimes used to provide access to the bloodstreamfor patients undergoing hemodialysis treatments. Existing small bore grafttechnologies suffer from a variety of disadvantages in the treatment of certainmedical conditions, depending upon the need for biodurability, compliance(elasticity) and other characteristics necessary for long-term interface withthe human body.

**ProductUnder  Development**

***CardioPassSynthetic Coronary Artery Bypass Graft (“SynCAB”)***

CABGsurgery is performed to treat the impairment of blood flow to portions of theheart. CABG surgery involves the addition of one or more new vessels to theheart to re-route blood around blocked coronary arteries.

Autologousgrafts (using the patient’s own saphenous vein, radial artery, or mammaryartery) have been successfully used in CABG procedures for a number of yearsand have shown a relatively high patency rate (80% to 90% for saphenous veinsand over 90% for mammary arteries one year after surgery) with no risk oftissue rejection. However, the surgical harvesting of vessels for autologousgrafts involves significant trauma and expense. In addition, not all patientsrequiring CABG surgery have sufficient native vessels as a result of previousbypass surgeries, or their vessels may be of inferior quality due to trauma ordisease. Cryo-preserved saphenous veins are available, but these veins oftendeteriorate due to attack by the body’s immune system.

CardioTechis developing its SynCAB grafts using specialized ChronoFlex polyurethanematerials that it believes should provide improved performance in the treatmentof arterial disorders. The grafts have three layers, similar to naturalarteries and are designed to replicate the physical characteristics of humanblood vessels.

TheCompany is developing a 5mm SynCAB graft. If successfully developed, theCompany believes the SynCAB graft may be used initially to provide analternative to patients with insufficient or inadequate native vessels for usein bypass surgery as a result of repeat procedures, trauma, disease or otherfactors. The Company believes, however, that the SynCAB graft may ultimately beused as a substitute for native saphenous veins, thus avoiding the trauma andexpense associated with the surgical harvesting of the vein.

The Company conductedlimited clinical evaluations of the SynCAB graft in three (3) patients inBrazil. As of March 31, 2006, the Company believes all three patients havehad an uneventful post-operative course. The Company initiated plans in fiscal2006 to obtain European marketing approvals. In May 2006, the Companyreceived written acknowledgement from its Notified Body in Europe that itsclinical trial plan had been accepted. Following the clinical trial, theanalyzed data will be submitted by CardioTech to the Notified Body in supportof its CE Mark application. The planned 10 patient clinical trial protocolallows surgeons to intraoperatively decide to use the SynCAB instead ofsuboptimal autologous vessels. Patients will be followed for 90 days andassessed for graft patency and quality of life measures. In June 2006, theCompany signed an agreement to develop innovative medical solutions for thetreatment of congestive heart failure. Development at the Company’s GishBiomedical rapid prototype laboratories will utilize proprietaryantithrombogenic Gish Biocompatible Surface (“GBS”) technology.

**CommercialProducts**

***CustomCardiovascular Tubing Systems***

Duringopen-heart surgery, the patient’s blood is diverted from the heart throughsterile plastic tubing and various other devices to an oxygenator device, whichoxygenates the blood before it is returned to the patient. Each hospitalperforming open-heart surgery specifies the components to be included in itscustom tubing sets, based on the particular needs of its surgical team. Thecomplexity of the sets varies from simple tubing systems to all-inclusiveoperating packs. The packs usually include blood filters, gas filters,reservoirs used to collect blood lost during surgery and other components. Gishproduces custom tubing sets using clear MediflexTM tubing. Such 

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components are assembled in the Gish clean room,sterilized and then shipped either to the hospital or to one of Gish’sspecialty distributors, which service such hospitals.

Customtubing systems are sold separately and combined with an oxygenator. Revenuesfrom sales of custom tubing systems sold separately equaled 12%, 12% and 13% oftotal Company revenues for fiscal 2006, 2005 and 2004, respectively.

***ArterialFilters***

Thearterial filter is the last device the blood passes through in thecardiovascular bypass circuit as it is being returned to the patient. Thepurpose of the filter is to remove gaseous micro emboli and debris, which aregenerated by the oxygenation system, from the patient’s blood.

Gishintroduced its first arterial filters in 1985. Gish’s first design contained asafety bypass loop incorporated into the filter housing. The Company receivedFDA clearance to market an improved design, which became available for saleduring the second quarter of fiscal 1994.

***CardiotomyReservoirs***

Cardiacsuction is a technique employed in open-heart surgery to recover shed blood inthe chest cavity and return it to the patient. The use of this techniquereduces the requirements for whole blood replacement from donor sources,thereby reducing the risk of blood compatibility problems and blood-borne viraldiseases such as AIDS and hepatitis.

TheCompany’s cardiotomy reservoir systems consist of a polycarbonate reservoir,defoaming and filtration cartridge, and mounting bracket. This enables theperfusion team to recover high volumes of shed blood, then defoam and filter itprior to returning it to the patient’s circulatory system.

Inaddition to the cardiotomy reservoirs’ use in the operating room, the Companyhas developed several systems that allow the cardiotomy reservoir to be used asa pleural drainage or autotransfusion system during recovery.

***VisionTMOxygenator***

Anoxygenator enables gas exchange of oxygen and carbon dioxide and also regulatesthe temperature of the patient’s blood. As a life sustaining device used duringopen-heart surgery, the oxygenator is a key component of the bypass circuit. Visionis assembled in a clean room using state of the art equipment and biocompatiblematerials, and then each unit is leak tested before shipment. Vision’s gastransfer performance is excellent, dependable and capable of maintaining theoxygen demands of patients of all sizes for periods of up to six hours.

Vision’sunique air separation channel utilizes an arterial outlet pressure gradient andthe natural buoyancy of air to minimize the passage of gaseous emboli towardsthe patient. Unwanted emboli are safely purged for safe venting back to thereservoir. Through studies at an independent testing facility, Vision’s airhandling abilities were proven superior to competitive devices.

TheVision oxygenator is sold separately, or with a reservoir, and also with areservoir and custom tubing system. The Vision oxygenator was sold in selectedaccounts both domestically and internationally for the first half of fiscal1998. The Company made its full market release of this product for sale in January 1998.The Company believes that the Vision oxygenator’s superior air handlingcapabilities provides the Company with a competitive advantage in theoxygenator market place. Revenue generated from sales that included anoxygenator equaled 27%, 32% and 31% of total Company revenues for fiscal 2006,2005 and 2004, respectively.

***VenousReservoirs***

Avenous reservoir is a device used to pool, filter and defoam blood prior to itsintroduction to the oxygenator. Gish offers a variety of venous reservoirs,including some which incorporate the capacity for autologous transfusion postsurgically. Gish also has several products that incorporate the functions ofcardiotomy, venous reservoir, post surgical blood collection and bloodreinfusion devices. This functional bundling is usually cost effective for thehospital.

***CAPVRF44***

TheCompany’s CAPVRF44 hardshell venous reservoir combines a 360° rotational,top-entry  1¤2 " inlet for unrestrictedvenous drainage and a high performance cardiotomy compartment with six suckerinlet ports to handle 

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all of the blood coming from the surgical field. TheCompany has incorporated the advantages of the depth filter in its cardiotomiesinto the CAPVRF44 for reduced hold-up volumes, making more blood available tothe patient. With an operating capacity of 4400 ml, the CAPVRF44 also has thecapacity to handle high blood volume procedures such as valve replacements andsecond surgeries.

TheCAPVRF44 is a perioperative device, capable of operating in both the Operating Room andRecovery Room. Following surgery, through a simple conversion process, theCAPVRF44 collects blood shed from the chest cavity and removes unwanted debrisbefore the filtered blood is reinfused back into the patient. Blood recoveryand autotransfusion through the CAPVRF44’s closed system limits hospital staffexposure to potential blood infections. Recovered blood may be reinfusedcontinuously, intermittently, or not at all, in support of all patients’religious beliefs, including Jehovah’s Witnesses. The CAPVRF44’s dual rolemeans fewer homologous blood products are needed, further reducing surgicalcosts and improving patient safety.

***CardioplegiaDelivery Systems***

Cardioplegiaencompasses several techniques employed in open-heart surgery to preserve,protect and manage the heart tissue. The technique typically involves the useof a chilled solution that is infused into the heart through the coronaryarteries to cool the heart and reduce heart activity and metabolism. However,there are many different techniques utilized, depending on the physician andpatient needs. The use of these techniques significantly reduces damage toheart tissue during surgery, enhances restoration of heart function and helpsreturn the patient to a normal heartbeat when the surgical procedure iscomplete.

The Companyhas developed a complete line of cardioplegia delivery systems, including a newcardioplegia device. In April 2002, the FDA granted the Company clearanceto sell the device in the United States of America. Additionally, the newcardioplegia device is CE marked, allowing sale in Europe. Multiple systems arerequired for this technique due to varying physician preferences. The Company’soriginal offerings for this procedure were a series of reservoirs with arecirculation valve (CPS) and a series of cooling coils (CCS series). TheCompany has since developed a line of cardioplegia systems and heat exchangersdesigned to utilize a blood and potassium mixture and allow the surgeon toquickly change the temperature delivered to the patient.

***OxygenSaturation Monitor***

In February 1992,the Company introduced a digital blood saturation monitor for open-heartsurgery, the StatSatTM.The StatSat is an electronic device that measures the oxygen content of thepatient’s blood during surgery. These readings are taken continuously and theStatSat plots the course of the blood oxygen saturation during the surgery. Althoughthe StatSat is reusable, it uses a disposable sensor for each surgery.

***CriticalCare Central Venous Access Catheters and Ports***

TheCompany’s Hemed central venous access catheter systems have applications inhyper-alimentation, chemotherapy, and long-term vascular access. Theselong-term indwelling catheters are surgically implanted to provide directaccess to the central venous system for high protein intravenous solutionsneeded by patients having nonfunctional digestive systems and for rapiddilution and dispersion of highly concentrated drug administration inchemotherapy for cancer.

Theproduct line includes sterile single, dual and triple lumen catheters andaccessories sold in kits. The triple lumen catheter, which permit threesubstances to be administered through the same catheter, was introduced duringfiscal 1997. In 1993, the Company introduced an enhancement to its Hemedcatheter line, the CathCap. The CathCap reduces the risk of infection at theinjection site by continually bathing the injection cap in an antimicrobialsolution between injections.

TheCompany has enhanced the Hemed line with the VasPort Implantable Ports and theVasTack Needle Support System. The VasPort consists of a silicone catheter withan implantable injection port, allowing vascular access through small needlesticks with the skin acting as a natural barrier to infection. This accessmethod eliminates the need for a cumbersome external catheter. The Companyintroduced a detachable port/catheter system in fiscal 1994. The Company alsointroduced a dual VasPort in July 1996 to meet the needs of patientsrequiring multiple infusions. The VasTack consists of a specially designedneedle and positioning system for use with the VasPort. The needle extends thelife of the implanted injection port and the positioning system gives thenursing staff a sure, safe method for accessing the VasPort.

TheHemed, VasPort and VasTack are alternative vascular access products used forextended long-term 

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infusion management and are designed to complement theHemed catheter lines. The VasPort is a device implanted entirely under the skinand consists of a small reservoir with a diaphragm and catheter. The VasPort isaccessed by the VasTack, a small patented non-coring needle system, whichpenetrates the skin and the diaphragm of the VasPort reservoir. Drugs arereadily infused through the VasTack, into the reservoir and then into thecatheter. When the infusion is complete the VasTack is removed and the skinacts as a natural barrier against infection. Single and double reservoirVasPorts are available.

***Orthofuser***

Thepatented OrthofuserTM is designed for post-operative use inorthopedic surgeries such as hip and knee replacements and provides for thesafe recovery and transfusion of the patient’s own blood. This product is wellsuited for orthopedic procedures, as it is portable and incorporates its owninternal vacuum source. Salvaging and reusing as little as 500cc’s of bloodpost surgically may be enough to avoid the use of donor blood in these types ofsurgeries.

***FDAClearance for Heparin Coated Products***

In fiscal 2004, the Company received FDA clearance forits heparin coating to be used in conjunction with Gish’s line of heart-lungbypass products. The GBSÔ (GishBiocompatible Surfaces) Coating is a heparin based, covalently boundbiocompatible coating that will be used to cover the surfaces of disposableproducts. Heparin coatings are known to inhibit blood coagulation, decrease therisk of Systemic Inflammatory Response Syndrome, reduce complement activationand platelet adhesion, reduce blood loss and hemolysis, provide stableantithrombotic activity and reduce thrombus formatiom, as well as decreaseleukocyte (white blood cells) activation.

In September 2005, the Company announced that itreceived FDA approval for certain heparin coated products for thecardiopulmonary bypass surgery market.

*Private Label Medical Devices*

CardioTech is a supplier of private-label advanceddisposable medical devices from concept to finished packaged and sterilizedproducts. Certain devices designed, developed and manufactured for customers byCDT include sensing, balloon, and drug delivery catheters; disposableendoscopes; and in-vitro diagnostic and surgical disposables.

**Biomaterials**

CardioTechdevelops, manufactures and sells a range of polymer-based materials customizedfor use in the manufacture of certain medical devices to other medical devicemanufacturers. CardioTech sells these custom polymers under the tradenamesChronoFilm, ChronoFlex, ChronoThane, ChronoPrene, HydroThane, PolyBlend andPolyWeld. The Company also provides development services relating tobiomaterials to medical device customers.

CardioTechalso manufactures and sells its proprietary HydroThane biomaterials to medicaldevice manufacturers that are evaluating HydroThane for use in their products. HydroThaneis a thermoplastic, water-absorbing, polyurethane elastomer, that possesses propertiesthat CardioTech believes make it well suited for the complex requirements of avariety of catheters. In addition to its physical properties, CardioTechbelieves HydroThane exhibits an inherent degree of bacterial resistance, clotresistance and biocompatibility. When hydrated, HydroThane has elasticproperties similar to living tissue.

In July 1999,CardioTech acquired the assets of Tyndale-Plains-Hunter, Ltd. (TPH), amanufacturer of specialty hydrophilic polyurethanes. These hydrophilic polyurethanesare primarily sold to customers as part of an exclusive arrangement. Certaincustomers are supplied tailored, patented hydrophilic polyurethanes in exchangefor multi-year, royalty-bearing exclusive supply contracts. The Company owns 29patents in the field of hydrophilic polyurethanes.

CardioTechcurrently manufactures limited quantities of ChronoFlex and HydroThane for saleto medical device manufacturers. To date, CardioTech’s manufacturing activitieswith respect to the specialized ChronoFlex materials used in vascular graftshave consisted primarily of manufacturing small quantities of such products foruse in clinical trials. The Company has an agreement with CTL, formerly asubsidiary of Nervation Ltd., pursuant to which the Company is required topurchase from and CTL has agreed to sell to the Company the vascular grafts itneeds, subject to the Company’s ability to obtain another supplier or to obtain“technology transfer.”  In May 2003,all of the assets of CTL were sold to LeMaitre Vascular Inc. By requesting “technologytransfer,” CardioTech retained the right to undertake large scale commercialproduction of vascular grafts, when, and if it elects to do 

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so. This would entail, among other things, thepurchase of specialized extrusion equipment capable of producing the grafts. Toachieve profitability, vascular graft products must be manufactured in largercommercial quantities in compliance with regulatory requirements and atacceptable costs. Production in larger commercial quantities will requireCardioTech to expand its manufacturing capabilities significantly and to hireand train additional personnel.

Thedevelopment and manufacture of CardioTech’s products are subject to goodlaboratory practice (“GLP”) and quality system regulations (“QSR”) requirementsprescribed by the Food and Drug Administration (“FDA”) and other standardsprescribed by the appropriate regulatory agency in the country of use. Therecan be no assurance that CardioTech will be able to obtain or manufactureproducts in a timely fashion at acceptable quality and prices, that it or anysuppliers can comply with GLP or the QSR, as applicable, or that it or suchsuppliers will be able to manufacture an adequate supply of products. Both theCalifornia and Minnesota facilities are ISO 13485 certified.

**ConsolidatedRevenues**

Companyrevenues were $22,381,000, $21,841,000 and $21,799,000 for the years ended March 31,2006, 2005 and 2004, respectively.

 **Competition**

Competitionin the medical device industry in general is intense and based primarily onscientific and technological factors, the availability of patent and otherprotection for technology and products, the ability to commercializetechnological developments and the ability to obtain governmental approval fortesting, manufacturing and marketing products.

Competitionamong products is based, among other things, on product efficacy, safety,reliability, availability, price and patent position. An important factor isthe timing of the market introduction of CardioTech’s or competitors’ products.Accordingly, the relative speed with which CardioTech can develop products,complete the clinical trials and approval processes and supply commercialquantities of the products to the market is expected to be an importantcompetitive factor. CardioTech’s competitive position depends upon its abilityto attract and retain qualified personnel, to obtain patent protection orotherwise develop proprietary products or processes, and to secure sufficientcapital resources for the often substantial period between technologicalconception and commercial sales.

Themarket for medical devices of the type sold by the Company is extremelycompetitive. The Company believes that product differentiation and performance,client service, reliability, cost and ease of use are important competitiveconsiderations in the markets in which it competes. Most of the Company’scompetitors are larger and possess greater financial and other resources thanthe Company. The Company has approximately four competitors within each of thehospital markets in which it competes. No one competitor is a dominant force inthis market. The Company believes it has achieved its position in themarketplace for its present principal products by means of superior design,quality, and service, and the Company intends to continue to utilize thesemeans of competing.

**Researchand Development, Regulatory and Engineering**

CardioTech’sresearch and development efforts are primarily focused on developing itssynthetic vascular graft technologies. CardioTech’s development decisions arebased on: (i) development costs, (ii) product need, (iii) third-partyinterest and funding availability, and (iv) regulatory considerations. Researchand development, regulatory and engineering expenditures for the years ended March 31,2006, 2005 and 2004 were $1,385,000, $1,258,000 and $1,065,000, respectively,and consisted primarily of salaries and related costs (57%, 60% and 72% infiscal 2006, 2005 and 2004, respectively), and are expensed as incurred. Inthis income statement category, the Company has six full time employees andallocates a portion Dr. MichaelSzycher’s salary and related costs to thisincome statement category.

In April 2002,the Company concluded a technology transfer and license agreement with CredentVascular Technologies, Ltd., of Wrexham, U.K. (“Credent”). Total considerationpaid by Credent to CardioTech for the purchase of the transferred rights toChronoFlex RC was $500,000. Credent paid CardioTech $400,000 in fiscal 2004 and$100,000 in fiscal 2003.

Underterms of the agreement, CardioTech irrevocably granted an exclusive, worldwidelicense of its intellectual property rights relating to ChronoFlex RC, enablingCredent to exclusively synthesize ChronoFlex RC biodurable polycarbonate-urethane.Credent will use ChronoFlex RC in the manufacture of its vascular access andperipheral vascular grafts and potentially in future development products. Credenthas licensed back to CardioTech 

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the right to use ChronoFlex RC for the manufacture andmarketing of coronary artery bypass grafts.

**GovernmentRegulation**

CardioTech’sdevices, as well as other medical devices that we may develop, are subject toextensive regulation by the FDA and other regulatory authorities in the U.S.and abroad. The Federal Food, Drug, and Cosmetic Act (the “FDC Act”) and otherfederal and state statutes and regulations govern the research, design,development, manufacturing, preclinical and clinical testing, installation,storage, packaging, recordkeeping, servicing, labeling, distribution andpromotion of medical devices in the U.S.

As adevice manufacturer, the Company is also required to register with the FDA. Assuch, the Company is  subject toinspection on a routine basis for compliance with the FDA’s Quality Systemsregulations. These regulations require that the Company manufactures itsproducts and maintain its documents in a prescribed manner with respect tomanufacturing, testing and control activities. Further, the Company is requiredto comply with various FDA requirements for reporting. The FDC Act and medicaldevice reporting regulations require that the Company provides information tothe FDA on deaths or serious injuries alleged to have been caused orcontributed to by the use of its products, as well as product malfunctions thatwould likely cause or contribute to death or serious injury if the malfunctionwere to recur. The FDA also prohibits an approved device from being marketedfor unapproved uses. The Company’s product promotion and advertising is subjectto continuing FDA regulation. The failure to comply with the applicableregulatory requirements may subject the Company to a variety of administrativeor judicially imposed sanctions, including the FDA’s refusal to approve pendingor supplemental applications, withdrawal of an approval or clearance, warningletters, product recalls, product seizures, total or partial suspension ofproduction or distribution, injunctions, fines, and civil and criminalpenalties against that company or its officers, directors or employees. Failureto comply with regulatory requirements could have a material adverse effect onthe Company’s business, financial condition and results of operations.

TheCompany intends to continuously improve its products after market introduction and may therefore submit futureInvestigational Device Exemption, Pre-Market Notification (“510(k)”),Pre-Market Approval (“PMA”), or PMA supplement applications to the FDA. Noassurance can be given that clearance or approval of such new applications willbe granted by the FDA on a timely basis, or at all. Furthermore, the Companymay be required to submit extensive preclinical and clinical data depending onthe nature of the changes.

Fromtime to time, legislation is drafted and introduced in Congress that couldsignificantly change the statutory provisions governing the approval,manufacturing and marketing of drug products and medical devices. In addition,FDA regulations and guidance are often revised or reinterpreted by the agencyin ways that may significantly affect our business and our products. It isimpossible to predict whether legislative changes will be enacted, or FDAregulations, guidance, or interpretations changed, and what the impact of suchchanges, if any, may be.

Various foreign countries in which the Company’s products are or may besold impose additional or different regulatory and testing requirements. Theinternational regulatory approval process varies from country to country and issubject to change in a given country as regulatory requirements change. Thus,the time required for an approval may differ and there can be substantialdelays in obtaining approval after the relevant applications are filed. Thereis no assurance that foreign regulatory authorities will approve the use orsale of our products in a particular country on a timely basis, or at all. CardioTech’sresearch and development activities are also subject to regulation for safety,efficacy and quality by numerous governmental authorities in the United States.In the United States, the development, manufacturing and marketing of syntheticvascular grafts are subject to regulation for safety and efficacy by the FDA inaccordance with the Food, Drug and Cosmetic Act. Synthetic vascular grafts aresubject to rigorous FDA regulation, including pre-clinical and clinical testing.The process of completing clinical trials and obtaining FDA approvals formarketing a medical device is likely to take a number of years, requires theexpenditure of substantial resources and is often subject to unanticipateddelays. There can be no assurance that any product will receive such approvalon a timely basis, if at all. Furthermore, CardioTech or the FDA may suspendclinical trials at any time upon a determination that the subjects or patientsare being exposed to an unacceptable adverse health risk ascribable toCardioTech’s products. If clinical studies are suspended, CardioTech may beunable to continue the development of the investigational products affected.

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Gishand CDT are registered as a medical device manufacturer with the FDA and stateagencies. Gish and CDT are inspected periodically by both the FDA and the stateagencies for compliance with the FDA’s GMP and other requirements including themedical device reporting regulation and various requirements for labeling andpromotion. The FDA Quality System Regulations (“QSR”), which became effective June 1,1997, no longer limit control to manufacturing and post market controls, butspecify requirements during design (Design Control), manufacturing, andservicing as well. Much of the new QSR is based on the ISO 13485 QualityStandard, and is, as such in harmony with the thrust towards worldharmonization of medical device requirements. The FDA’s GMP regulationrequires, among other things, that (i) the manufacturing process beregulated and controlled by the use of written procedures, and (ii) theability to produce devices that meet the manufacturer’s specifications bevalidated by extensive and detailed testing of every aspect of the process. Themedical device reporting regulation requires that the device manufacturerprovide information to the FDA on deaths or serious injuries alleged to havebeen associated with the use of its marketed devices, as well as productmalfunctions that would likely cause or contribute to a death or serious injuryif the malfunction were to recur. Changes in existing requirements orinterpretations (on which regulations heavily depend) or adoption of newrequirements or policies could adversely affect the ability of the Company tocomply with regulatory requirements. Failure to comply with regulatoryrequirements could have a material adverse effect on the Company’s business.

TheCompany believes all of its present products are in compliance in all materialrespects with all applicable performance standards as well as goodmanufacturing practices, record keeping and reporting requirements in theproduction and distribution of such products. Most of Gish’s products have beendetermined by the FDA to be devices substantially similar to devices marketedby others prior to May 28, 1976, the effective date of the Amendments, andmarketing of them has been authorized pending the classification by the FDA ofsuch products. Gish does not anticipate any significant difficulty or materialcost increases in complying with applicable performance standards if any suchproducts were to be classified in Class II by the FDA. If the FDA were toclassify use of Gish’s cardiovascular or catheter products as Class IIIproducts, pre-marketing clinical testing and evaluation would be required inorder to obtain FDA approval for the sale of such products.

Healthcareproviders, including hospitals and physicians that purchase medical devices,for use on their patients, generally rely on third-party payers, principallyMedicare, Medicaid and private health insurance plans, to reimburse all or partof the costs associated with the procedures performed with these devices.  Devices produced by Gish are reimbursed underDiagnostic Related Groups “DRG” for the specific surgical procedure in whichthey are utilized. There is no specific reimbursement for the productsthemselves.

**Marketing andDistribution**

Internationally,Gish is represented by specialty medical distributors in over fifty countriesaround the world. Gish’s international sales represented approximately 14%, 17%and 15% of total Company sales in fiscal 2006, 2005 and 2004, respectively. TheCompany’s sales to foreign customers are primarily in Europe and Asia. Allinternational transactions are conducted in U.S. dollars, thus reducing therisk from currency fluctuations. The Company does not have any facilities,property or other assets, except sales representative supplies, located in anygeographic area other than the United States of America.

TheCompany markets and distributes its cardiopulmonary products through a networkof direct and independent sales representatives. The Company markets anddistributes its biomaterials and private label medical device products and servicesdirectly to its customers.

TheCompany has not experienced, and does not expect to experience sales of theCompany’s products to be subject to seasonality in any material respect.

**Componentsand Parts**

Gishpurchases components for its various products from vendors who sell suchcomponents generally to the medical device industry. Most components for theCompany’s proprietary products are manufactured from tooling owned by theCompany. Other components are manufactured by outside suppliers in accordancewith the Company’s specifications.

Certaincomponents of Gish’s custom tubing sets are purchased from competitors. Gishhas not experienced difficulty in obtaining such components in the past andbelieves adequate sources of supply for such items are available on reasonableterms.

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MembranaGmbH is a principal supplier of the Company and provides a polyester wrapthread for use in the VisionÔOxygenator.

**Patentsand License Agreements**

TheCompany has been issued or has patents pending on several of its products. Therecan be no assurance that any patents issued would afford the Company adequateprotection against competitors which sell similar inventions or devices. Therealso can be no assurance that the Company’s patents will not be infringed uponor designed around by others. However, the Company intends to vigorouslyenforce all patents it has been issued.

**CustomerInformation**

TheCompany performs ongoing credit evaluations and maintains allowances forpotential credit losses. As of March 31, 2006, the Company believes it hasno significant concentrations of credit risk.

Oneof Gish’s sales representative organizations comprised 5%, 4% and 2% of theCompany’s revenues in fiscal 2006, 2005 and 2004, respectively. The Companybelieves that the loss of this sales representative organization would not havea material effect on its business.

**Backlog**

Almostall of Gish’s products are repetitive purchase, single use, disposableproducts, which are shipped shortly after receipt of a customer’s purchaseorder. Therefore, Gish believes that the Company and its distributors generallymaintain an adequate finished goods inventory to fulfill the customer’s needson demand. Accordingly, Gish believes that the backlog of orders at any givenpoint in time is not indicative of the Company’s future level of sales.

CDThad a backlog of $991,000 at March 31, 2006.

**Contractsand Material Relationship**

Ingeneral, the Company does not enter into long-term contracts with customers orsuppliers, however, if there were cancellation or renegotiation of currentrelationships, there could be a material impact on the Company’s revenues orprofit margins.

Beginningin fiscal 2005 and continuing into fiscal 2006, the Company started shippingbranded catheter products on a purchase order basis to a major customer (the “Intermediary”),who would then perform additional manufacturing processes and ship theseproducts to the end user (the “End User”). These products were previouslydeveloped by the End User who then transferred manufacturing to theIntermediary. The Intermediary then engaged the Company to manufacture theproducts. In March 2006, the End User sought to directly source productsfrom the Company.

On May 18,2006, the Company was notified by the End User that the End User had decided tocease using the Company for future production. During this time, the End Useralso began an alliance with a competitive supplier of branded catheters.

TheEnd User’s decision in May 2006 was due to concerns about supplyconstraints related to production specifications. The Company has agreed to,and is in process of completing, the following actions in order to provide theEnd User with objective information to decide whether the End User will engagethe Company for future production. First, all products in question by the EndUser will be identified, inspected and/or reworked by the Company. Secondly,the Company will jointly evaluate these products with the End User so that theEnd User can determine, in its sole discretion, whether: (i) the Company’sproducts are now consistent with the End User’s specifications and (ii) tobegin ordering products from the Company.

As aresult of the End User’s current decision to cease using the Company for futureproduction, the Company recorded charges in the fourth quarter of fiscal 2006 of$598,000 for the impairment of goodwill and $556,000 for the impairment of custominventory held by the Company related to the Company’s production of productsfor the End User.

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**EnvironmentalCompliance**

TheCompany’s direct expenditures for environmental compliance were not material inthe three (3) most recent fiscal years. However, certain costs ofmanufacturing have increased due to environmental regulations placed uponsuppliers of components and services.

**Employees**

Asof March 31, 2006, the Company has 11 full-time employees at itsheadquarters in Massachusetts, consisting of 4 in Biomaterials and theremaining in management, administrative, and marketing positions.

Asof March 31, 2006, the Company has 56 full-time employees in Minnesota, 18are in contract research and development, 35 are in manufacturing andproduction, and 3 are in management, administrative, and marketing positions. Inaddition, during fiscal 2006 the Company used contract manufacturing personnelto meet the production needs for the Intermediary and the End User. Duringfiscal 2006, the maximum number of contract manufacturing personnel used was 48.As of March 31, 2006, the Company had 42 contract manufacturing personnelengaged in manufacturing and production.

Asof March 31, 2006, the Company’s California operations has 97 full-timeemployees, of whom 4 were engaged in sales and sales management, 76 wereengaged in manufacturing and the remainder in marketing, research anddevelopment, administrative and executive positions.

Noneof these employees are covered by a collective bargaining agreement, andmanagement considers its relations with its employees to be good.

**Item 1A.**                 Risk Factors

Youshould carefully consider the risks and uncertainties described below and theother information in this filing before deciding to purchase our common stock. Ifany of these risks or uncertainties occurs, our business, financial conditionor operating results could be materially harmed. In that case the trading priceof our common stock could decline and you could lose all or part of yourinvestment. The risks and uncertainties described below are not the only oneswe may face. CardioTech believes that this filing contains forward-lookingstatements as that term is defined in the Private Securities Litigation ReformAct of 1995. Such forward-looking statements are subject to regulatory risksand clinical uncertainties. Such statements are based on management’s currentexpectations and are subject to facts that could cause results to differmaterially from the forward-looking statements. For further information you areencouraged to review CardioTech’s filings with the Securities and ExchangeCommission, including its Quarterly Reports on Form 10-Q for theperiods ended June 30, 2005, September 30, 2005, and December 31,2005. The Company assumes no obligation to update the information contained inthis filing.

**RisksRelated to Liquidity**

*We havereported net losses in the last four fiscal years and may continue to reportnet losses in the future. We cannot assure you that our revenue will bemaintained at the current level or increase in the future.*

The Company’s futuregrowth may depend on its ability to raise capital for acquisitions and tosupport research and development activities, including costs for clinicaltrials, and to market and sell its vascular graft technology, specifically thecoronary artery bypass graft. CardioTech may require substantial funds forfurther research and development, future pre-clinical and clinical trials,regulatory approvals, establishment of commercial-scale manufacturingcapabilities, and the marketing of its products. CardioTech’s capitalrequirements depend on numerous factors, including but not limited to, theprogress of its research and development programs, including costs for clinicaltrials; the cost of filing, prosecuting, defending and enforcing anyintellectual property rights; competing technological and market developments;changes in CardioTech’s development of commercialization activities andarrangements; and the purchase of additional facilities and capital equipment.

**RisksRelated to Our Growth Strategy**

*We could experience rapid growththat could strain our managerial and other resources.*

Since becoming listed onthe American Stock Exchange in June of 1996 we have grown organically, andthrough the acquisition of three separate businesses. In July 1999, weacquired the business of Tyndale-Plains Hunter, Ltd.; in May 2001, we acquiredCatheter and Disposables Technology, Inc.; and in April 2003, weacquired Gish Biomedical, Inc. While we are not currently considering anacquisition, we may make additional acquisitions of complementary medicalmanufacturing service providers that bring desired capabilities, customers orgeographic coverage and either strengthen our position in our target markets orprovide us with a presence in a new market. 

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The risks we may encounter in pursuing theseacquisitions, if any, include expenses associated with, and difficulties inidentifying, potential targets, costs associated with acquisitions weultimately are unable to complete and higher prices for acquired companies dueto competition for attractive targets. Completing acquisitions also may resultin dilution to our existing stockholders and may require us to seek additionalcapital, if available, including increasing our indebtedness.

Once acquired, thesuccessful integration and operation of a business requires communication andcooperation among key managers, the transition of customer relationships, themanagement of ongoing projects of acquired companies and the management of newprojects across previously independent facilities.

Customer satisfaction orperformance problems with an acquired company could also harm our reputation asa whole, and any acquired business could significantly under perform relativeto our expectations. For all these reasons, our pursuit of an overallacquisition strategy or any individual completed, pending or future acquisitionmay adversely affect the realization of our strategic goals.

In addition, while we mayobtain cost savings, operating efficiencies and other synergies as a result ofpossible future acquisitions, the consolidation of functions and the integrationof departments, systems and procedures present significant managementchallenges.

The acquisition of newoperations can also introduce new types of risks to our business. For example,new acquisitions may require greater effort to address United States Food andDrug Administration, or FDA, regulation or similar foreign regulation.

*If we cannot obtain theadditional capital required to fund our operations, if needed, on favorableterms or at all, we may have to delay or reconsider our growth strategy.*

Our growth strategy mayrequire additional capital for, among other purposes, completing acquisitionsof companies and customers’ product lines and manufacturing assets, integratingacquired companies and assets, acquiring new equipment and maintaining thecondition of existing equipment. If cash generated internally is insufficientto fund capital requirements, or if we desire to make additional acquisitions,we will require additional debt or equity financing. Adequate financing may notbe available or, if available, may not be available on terms satisfactory to us.If we raise additional capital by issuing equity or convertible debtsecurities, the issuance may dilute the share ownership of the existinginvestors. In addition, we may grant future investors rights that are superiorto those of our existing investors. If we fail to obtain sufficient additionalcapital in the future, we could be forced to curtail our growth strategy byreducing or delaying capital expenditures and acquisitions, selling assets orrestructuring or refinancing our indebtedness, or delaying plans for clinicaltrials.

**RisksRelated to Our Business**

*We have incurred substantialoperating losses and we may never be profitable.*

The Company’s revenueswere $22,381,000, $21,841,000 and $21,799,000 for the years ended March 31,2006, 2005 and 2004, respectively. We had net losses of $5,069,000, $1,595,000and $1,515,000 for the years ended March 31, 2006, 2005 and 2004,respectively. There is a risk that we will never be profitable. None of ourcoronary artery graft products and technologies have ever been utilized on alarge-scale commercial basis and it may take several years before theseproducts could be commercialized, if ever. Our ability to generate enoughrevenues to achieve profits will depend on a variety of factors, many of whichare outside our control, including:

·                  sizeof market;

·                  competitionand other solutions;

·                  extentof patent and intellectual property protection afforded to our products;

·                  costand availability of raw material and intermediate component supplies;

·                  changesin governmental (including foreign governmental) initiatives and requirements;

·                  changesin domestic and foreign regulatory requirements;

·                  costsassociated with equipment development, repair and maintenance; and

·                  theability to manufacture and deliver products at prices that exceed our costs.

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*A substantial amount of ourassets comprise goodwill and other intangibles, and our net loss will increaseif our goodwill becomes impaired.*

As of March 31, 2006and 2005, goodwill represented approximately $487,000, or 2.4%, and $1,638,000,or 6.9%, respectively, of our total assets and net amortizable intangiblesrepresented approximately $584,000, or 2.8%, and $776,000 and 3.3%,respectively, of our total assets. The Company recorded a charge of $598,000for the impairment of goodwill related to its private label medical device manufacturingdivision primarily due to the End User’s May 2006 decision, as describedabove. In addition, the Company recorded a charge of $554,000 for theimpairment of goodwill related to its cardiopulmonary products division due tocontinued reduced demand for these products.

Goodwill is generated inour acquisitions when the cost of an acquisition exceeds the fair value of thenet tangible and identifiable intangible assets we acquire. Goodwill is nolonger amortized under generally accepted accounting principles as a result ofSFAS No. 142. Instead, goodwill is subject to an impairment analysis,performed at least annually, based on the fair value of the reporting unit. Amortizableintangible assets are subject to SFAS No. 144, and are subject to periodicreviews for impairment, or as events and circumstances indicate that thecarrying amount may not be recoverable. We could be required to recognizefuture reductions in our net income caused by the write-down of goodwill andother intangibles, if impaired, that, if significant, could materially andadversely affect our results of operations.

*Our operating results fluctuate. Ifwe fail to meet the expectations of securities analysts or investors, our stockprice may decrease. Our operating results have fluctuated in the past fromquarter to quarter and are likely to fluctuate significantly in the future dueto a variety of factors, many of which are beyond our control, including:*

·                  changingdemand for our products and services;

·                  thetiming of actual customer orders and requests for product shipment and theaccuracy of our customers’ forecasts of future production requirements;

·                  thereduction, rescheduling or cancellation of product orders and development anddesign services requested by customers;

·                  difficultiesin forecasting demand for our products and the planning and managing ofinventory levels;

·                  theintroduction and market acceptance of our customers’ new products and changesin demand for our customers’ existing products;

·                  resultsof clinical trials;

·                  changesin the relative portion of our revenue represented by our various products,services and customers, including the relative mix of our business across ourtarget markets;

·                  changesin competitive or economic conditions generally or in our customers’ markets;

·                  competitivepressures on selling prices;

·                  theamount and timing of costs associated with product warranties and returns;

·                  changesin availability or costs of raw materials or supplies;

·                  fluctuationsin manufacturing yields and yield losses and availability of productioncapacity;

·                  changesin our product distribution channels and the timeliness of receipt of distributorresale information;

·                  theimpact of vacation schedules and holidays, largely during the second and thirdfiscal quarters of our fiscal year;

·                  theamount and timing of investments in research and development;

·                  difficultiesin integrating acquired assets and businesses into our operations;

·                  chargesto earnings resulting from the application of the purchase method of accountingfollowing acquisitions; and

·                  pressureon our selling prices as a result of healthcare industry cost containmentmeasures.

As a result of thesefactors, many of which are difficult to control or predict, as well as theother risk factors discussed in this report, we may experience material adversefluctuations in our future operating results on a quarterly or annual basis.

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***Themedical device industry is cyclical, and an industry downturn could adverselyaffect our operating results.***

Business conditions inthe medical device industry have rapidly changed between periods of strong andweak demand. The industry is characterized by:

·                  periodsof overcapacity and production shortages;

·                  cyclicaldemand for products;

·                  changesin product mix in response to changes in demand of products;

·                  variationsin manufacturing costs and yields;

·                  rapidtechnological change and the introduction of new products by customers;

·                  priceerosion; and

·                  expendituresfor product development.

These factors could harmour business and cause our operating results to suffer.

***Thefailure to complete development of our medical technology, obtain governmentapprovals, including required FDA approvals, or to comply with ongoinggovernmental regulations could delay or limit introduction of our proposedproducts, negatively impact our operations and result in failure to achieverevenues or maintain our ongoing business.***

Our research, developmentand production activities, including the manufacture and marketing of ourintended coronary artery bypass graft product, are subject to extensiveregulation for safety, efficacy and quality by numerous government authoritiesin the United States and abroad.

Before receiving FDAclearance to market our proposed graft, we will have to demonstrate that ourgrafts are safe and effective on the patient population. While we have donesome preliminary animal trials and have seen acceptable results, there can beno assurance that acceptable results will be obtained in human trials. Clinicaltrials, manufacturing and marketing of medical devices are subject to therigorous testing and approval process of the FDA and equivalent foreign regulatoryauthorities. The Federal Food, Drug and Cosmetic Act and other federal, stateand foreign statutes and regulations govern and influence the testing,manufacture, labeling, advertising, distribution and promotion of drugs andmedical devices. As a result, clinical trials and regulatory approval of thecoronary artery bypass graft can take a number of years or longer to accomplishand require the expenditure of substantial financial, managerial and otherresources.

In order to becommercially viable, we must successfully research, develop, obtain regulatoryapproval, manufacture, market and distribute our grafts. For each deviceincorporating our artificial grafts, we must successfully meet a number ofcritical developmental milestones, including:

·                  demonstratebenefit from the use of our grafts in various contexts such as coronary arterybypass surgery;

·                  demonstratethrough pre-clinical and clinical trials that our grafts are safe andeffective; and

·                  establisha viable Good Manufacturing Process capable of potential scale up.

The time frame necessaryto achieve these developmental milestones may be long and uncertain, and we maynot successfully complete these milestones for any of our intended products indevelopment.

In order to conductclinical trials that are necessary to obtain approval by the FDA to market aproduct, it is necessary to receive clearance from the FDA to conduct suchclinical trials. The FDA can halt clinical trials at any time for safetyreasons or because we or our clinical investigators do not follow the FDA’srequirements for conducting clinical trials. If we are unable to receiveclearance to conduct clinical trials or the trials are halted by the FDA, wewould not be able to achieve any revenue from such product as it is illegal tosell any medical device for human consumption without FDA approval.

We are also a medicaldevices contract manufacturing services provider. Some of the products andcomponents of products that we manufacture may be considered finished medicaldevices, and the manufacturing processes used in the production of finishedmedical devices are subject to FDA inspection and assessment, and must complywith the FDA quality system regulation. The FDA quality system regulationestablishes good manufacturing practice requirements for product design,manufacture, management, packaging, labeling, distribution, and installationfor medical devices. Additional FDA regulations impose requirements for recordkeeping, reporting, facility and product registration, product safety andeffectiveness, and product tracking. Failure to comply with these regulatory 

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requirements may result in civil and criminalenforcement actions, including financial penalties, seizures, injunctions andother measures. Our products must also comply with state and foreignrequirements. Also, in order to comply with regulatory requirements, ourcustomers may wish to audit our operations to evaluate our quality systems.

In addition, the FDA andstate and foreign governmental agencies regulate many of our customers’products as medical devices. FDA approval is required for those products priorto commercialization in the United States, and approval of regulatoryauthorities in other countries may also be required prior to commercializationin those jurisdictions.

More generally, themanufacture and sale of medical devices, including products currently sold bythe Company and the Company’s other potential products, are subject toextensive regulation by numerous governmental authorities in the United States,principally the FDA, and corresponding state agencies, such as the CDHS. Inorder for the Company to market its products for clinical use in the UnitedStates, the Company must obtain clearance from the FDA of a 510(k) pre-marketnotification or approval or a more extensive submission known as a pre-marketapproval (“PMA”) application. In addition, certain material changes to medicaldevices also are subject to FDA review and clearance or approval. The processof obtaining FDA and other required regulatory clearances and approvals islengthy, expensive and uncertain, frequently requiring from one to severalyears from the date of FDA submission if pre-market clearance or approval isobtained at all. Securing FDA clearances and approvals may require thesubmission of extensive clinical data and supporting information to the FDA.

Sales of medical devicesoutside of the United States are subject to international regulatoryrequirements that vary from country to country. The time required to obtainapproval for sales internationally may be longer or shorter than that requiredfor FDA clearance or approval, and the requirements may differ. The Company hasentered into distribution agreements for the foreign distribution of itsproducts. These agreements generally require that the foreign distributor isresponsible for obtaining all necessary regulatory approvals in order to allowsales of the Company’s products in a particular country. There can be noassurance that the Company’s foreign distributors will be able to obtainapproval in a particular country for any future products of the Company.

Regulatory clearances orapprovals, if granted, may include significant limitations on the indicateduses for which the product may be marketed. In addition, to obtain suchclearances or approvals, the FDA and certain foreign regulatory authoritiesimpose numerous other requirements with which medical device manufacturers mustcomply.

FDA enforcement policystrictly prohibits the marketing of cleared or approved medical devices foruncleared or unapproved uses. In addition, product clearances or approvalscould be withdrawn for failure to comply with regulatory standards or theoccurrence of unforeseen problems following initial marketing. The Company willbe required to adhere to applicable FDA GMP regulations and similar regulationsin other countries, which include testing, control, and documentationrequirements. Ongoing compliance with GMP and other applicable regulatoryrequirements, including marketing products for unapproved uses, could resultin, among other things, warning letters, fines, injunctions, civil penalties,recall or seizure of products, total or partial suspension of production,refusal of the government to grant pre-market clearance or pre-market approvalfor devices, withdrawal of clearances or approvals and criminal prosecution. Changesin existing regulations or adoption of new governmental regulations or policiescould prevent or delay regulatory approval of the Company’s products.

There can be no assurancethat the Company will be able to obtain FDA 510(k) clearance or PMA forits products under development or other necessary regulatory approvals orclearances on a timely basis or at all. Delays in receipt of or failure toreceive U.S. or foreign clearances or approvals, the loss of previouslyobtained clearance or approvals, or failure to comply with existing or futureregulatory requirements would have a material adverse effect on the Company’sbusiness, financial condition and results of operations.

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***Ourmarkets are subject to technological change and our success depends on ourability to develop and introduce new products, primarily in cardiothoracicsurgery.***

The cardiothoracic marketfor our products is characterized by:

·                  changingtechnologies;

·                  changingcustomer needs;

·                  frequentnew product introductions and enhancements;

·                  increasedintegration with other functions; and

·                  productobsolescence.

The Company’s success isdependent in part on the design and development of new products in the medicaldevice industry. To develop new products and designs for our cardiothoracicmarket, we must develop, gain access to and use leading technologies in a costeffective and timely manner and continue to expand our technical and designexpertise. The product development process is time-consuming and costly, andthere can be no assurance that product development will be successfullycompleted, that necessary regulatory clearances or approvals will be granted bythe FDA on a timely basis, or at all, or that the potential products willachieve market acceptance. Failure by the Company to develop, obtain necessaryregulatory clearances or approvals for, or successfully market potential newproducts could have a material adverse effect on the Company’s business,financial condition and results of operations.

***Thenumber of patients undergoing bypass surgery may continue to decline, resultingin a reduction of our market potential.***

Over the past severalyears, the total number of patients undergoing bypass surgery has decreased asa result of new, less invasive therapies such as pharmacotherapy, angioplastyand stenting. We cannot assure you that the number of patients will notcontinue to decline as further medical advances are introduced. Any futuredecline in the total number of patients undergoing bypass surgery could resultin lost revenue and therefore could have a material adverse effect on ourbusiness, financial condition and results of operations.

***Wehave limited manufacturing experience and if our coronary bypass graft isapproved, we may not be able to manufacture sufficient quantities at anacceptable cost.***

We remain in the researchand development phase of our arterial grafts. Accordingly, if our products areapproved for commercial sale, we will need to establish the capability tocommercially manufacture our product(s) in accordance with FDA and otherregulatory requirements. We have limited experience in establishing,supervising and conducting commercial manufacturing. If we fail to adequatelyestablish, supervise and conduct all aspects of the manufacturing processes, wemay not be able to commercialize our products. We do not presently ownmanufacturing facilities necessary to provide clinical or commercial quantitiesof our intended graft. We may not be able to obtain such facilities at aneconomically feasible cost, or at all.

We presently rely on athird party contractor, LeMaitre Vascular Products, Inc., to manufactureall of our coronary grafts for our limited use. This exposes us to the risk ofnot being able to directly oversee the production and quality of themanufacturing process. This contractor has informed us that it is closing itsfacility in the United Kingdom where it manufactures our grafts and will betransporting machinery to the United States. They may experience regulatorycompliance difficulty, difficulty in re-assembling the machinery, mechanicalshut downs, employee strikes, or any other unforeseeable event that may delayproduction. Furthermore, LeMaitre has developed an expertise in themanufacturing process with machinery that may not get transferred to us. If weelect to produce the grafts ourselves, this may delay production and adverselyaffect our business. Pursuant to an agreement, we have requested that LeMaitreact in good faith to transfer the technology to us in exchange for payment ofpersonnel time plus 40% uplift. Such transfer has not yet been requested by theCompany.

***Wedepend on outside suppliers and subcontractors, and our production andreputation could be harmed if they are unable to meet our volume and qualityrequirements and alternative sources are not available.***

The Company has various “solesource” suppliers who supply key components for the Company’s products. Ouroutside suppliers may fail to develop and supply us with products andcomponents on a timely basis, or may supply us with products and componentsthat do not meet our quality, quantity or cost requirements. If any of theseproblems occur, we may be unable to obtain substitute sources of these productsand components on a timely basis or on terms acceptable to us, which could harmour ability to: i) manufacture our own products and components profitably or ontime, and ii) ship products to customers on time and generate revenues. Inaddition, if the processes 

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that our suppliers use to manufacture products andcomponents are proprietary, we may be unable to obtain comparable componentsfrom alternative suppliers.

***Asignificant portion of the revenue comes from relatively few large customers,and any decrease in sales to these customers could harm our operating results.***

The medical deviceindustry is concentrated, with relatively few companies accounting for a largepercentage of sales in the surgical, interventional and cardiovascular marketsthat are targeted by our disposable medical device and contract manufacturingoperations. Accordingly, our revenue and profitability are dependent on ourrelationships with a limited number of large medical device companies. We arelikely to continue to experience a high degree of customer concentration in ourdisposable medical device and contract manufacturing operations, particularlyif there is further consolidation within the medical device industry. We cannotassure you that there will not be a loss or reduction in business from one ormore of our large customers. In addition, we cannot assure you that revenuesfrom our customers that have accounted for significant revenues in the past,either individually or as a group, will reach or exceed historical levels inany future period. The loss or a significant reduction of business from any ofour major customers would adversely affect our results of operations.

Aspreviously discussed in the *Contracts and MaterialRelationships* section of Item 1., the Company was notified on May 18,2006 that the End User had decided to cease using the Company for futureproduction of branded catheter products. The End User’s decision in May 2006was due to concerns about supply constraints related to productionspecifications. The Company has agreed to, and is in process of taking, certainpreviously discussed actions in order to provide the End User with objectiveinformation to decide whether the End User will engage the Company for futureproduction. However, there can be no assurance that, after the evaluation bythe End User of the branded catheter products produced by the Company, the EndUser will engage the Company for future production. If the End User does notorder products from the Company in the future, there could possibly be adecrease in revenues and profit margins.

***Ourability to grow and sustain growth levels may be adversely affected byslowdowns in the U.S. economy.***

Due to the recentdecrease in corporate profits, capital spending and consumer confidence, we haveexperienced weakness in certain of our end markets. We are primarilysusceptible when clients stop placing orders for us to build prototypes ordevelop certain specialized medical devices through our contract manufacturingoperations. The medical commercial markets, including bio-medical research anddevelopment and medical device manufacturing, could be affected by the pastslowdown in the U.S. economy. If an economic slowdown occurs and continues andcapital spending for research and development from our clients decreases, ourbusiness, financial condition and results of operations may be adverselyaffected.

***Wecould be harmed by litigation involving patents and other intellectual propertyrights.***

None of our patents orother intellectual property rights has been successfully challenged to date. However,in the future, we could be accused of infringing the intellectual propertyrights of other third parties. We also have certain indemnification obligationsto customers with respect to the infringement of third party intellectualproperty rights by our products. No assurance can be provided that any futureinfringement claims by third parties or claims for indemnification by customersor end users of our products resulting from infringement claims will not beasserted or that assertions of infringement, if proven to be true, will notharm our business.

In the event of anyadverse ruling in any intellectual property litigation, we could be required topay substantial damages, cease the manufacturing, use and sale of infringingproducts, discontinue the use of certain processes or obtain a license from thethird party claiming infringement with royalty payment obligations by us.

Any litigation relatingto the intellectual property rights of third parties, whether or not determinedin our favor or settled by us, is costly and may divert the efforts andattention of our management and technical personnel.

***Wemay not be able to protect our intellectual property rights adequately.***

Our ability to compete isaffected by our ability to protect our intellectual property rights. We rely ona combination of patents, trademarks, copyrights, trade secrets,confidentiality procedures and non-disclosure and licensing arrangements toprotect our intellectual property rights. Despite these efforts, we cannot becertain that the steps we take to protect our proprietary information will beadequate to prevent misappropriation of our technology, or that our competitorswill not independently develop technology that is substantially similar orsuperior to our technology. More specifically, we cannot assure you that anyfuture applications will be approved, or that any issued patents will provideus with competitive advantages or will not be challenged by third parties. Norcan we 

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assure you that, if challenged, our patents will befound to be valid or enforceable, or that the patents of others will not havean adverse effect on our ability to do business. Furthermore, others mayindependently develop similar products or processes, duplicate our products orprocesses or design their products around any patents that may be issued to us.

***Ourfuture success depends on the continued service of management, engineering andsales personnel and our ability to identify, hire and retain additionalpersonnel.***

Our success depends, to asignificant extent, upon the efforts and abilities of Dr. Michael Szycher,our chairman and chief executive officer, and other members of seniormanagement. The loss of the services of one or more of our senior management orother key employees could adversely affect our business. We do not maintain keyperson life insurance on any of our officers, employees or consultants.

There is intensecompetition for qualified employees in the medical industry, particularly forhighly skilled design, applications, engineering and sales people. We may notbe able to continue to attract and retain technologists, managers, or otherqualified personnel necessary for the development of our business or to replacequalified individuals who could leave us at any time in the future. Ouranticipated growth is expected to place increased demands on our resources, andwill likely require the addition of new management and engineering staff aswell as the development of additional expertise by existing managementemployees. If we lose the services of or fail to recruit engineers or othertechnical and management personnel, our business could be harmed.

***Periodsof rapid growth and expansion could place a significant strain on ourresources, including our employee base.***

To manage our possiblefuture growth effectively, we will be required to continue to improve ouroperational, financial and management systems. In doing so, we willperiodically implement new software and other systems that will affect ourinternal operations regionally or globally. Presently, we are upgrading ourenterprise resource planning software to integrate our operations. Theconversion process is complex and requires, among other things, that data fromour existing system be made compatible with the upgraded system. During thetransition to this upgrade, we could experience delays in ordering materials,inventory tracking problems and other inefficiencies, which could cause delaysin shipments of products to our customers.

Future growth will alsorequire us to successfully hire, train, motivate and manage our employees. Inaddition, our continued growth and the evolution of our business plan willrequire significant additional management, technical and administrative resources.We may not be able to effectively manage the growth and evolution of ourcurrent business.

***Weare exposed to product liability and clinical and pre-clinical liability riskswhich could place a substantial financial burden on us, if we are sued. Althoughwe have $5 million dollars in product liability insurance coverage, that amountmay not be sufficient to cover all potential claims made against us.Additionally, we face the risk of financial exposure to product liabilityclaims alleging that the use of devices that incorporate our products resultedin adverse effects.***

While we are not aware ofany claim at this time, our business exposes us to potential product liability,recalls and other liability risks that are inherent in the testing,manufacturing and marketing of medical products. We cannot assure you that suchpotential claims will not be asserted against us. In addition, the use in ourclinical trials of medical products that our potential collaborators maydevelop and the subsequent sale of these products by us or our potentialcollaborators may cause us to bear a portion of or all product liability risks.A successful liability claim or series of claims brought against us could havea material adverse effect on our business, financial condition and results ofoperations.

We cannot assure you thatwe will be able to obtain or maintain adequate product liability insurance onacceptable terms, if at all, or that such insurance will provide adequatecoverage against our potential liabilities. Furthermore, our current andpotential partners with whom we have collaborative agreements or our futurelicensees may not be willing to indemnify us against these types of liabilitiesand may not themselves be sufficiently insured or have a net worth sufficient tosatisfy any product liability claims. Claims or losses in excess of any productliability insurance coverage that may be obtained by us could have a materialadverse effect on our business, financial condition and results of operations. Wedo not currently carry recall insurance and we may be subject to significantrecall costs in the event of a recall.

Additionally, wecurrently assist in the development of certain medical products and prototypesfor third parties, including components in other products. Our contractmanufacturing operation produces components for medical 

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manufacturers used in products such as catheters anddisposable devices. Product liability risks may exist even for those medicaldevices that have received regulatory approval for commercial sale or even forproducts undergoing regulatory review. We currently carry $5 million in productliability insurance. Any defects in our products used in these devices couldresult in recalls and/or significant product liability costs to us, which mayexceed $5 million. We do not currently carry recall insurance and we may besubject to significant recall costs in the event of a recall.

***Wemay be affected by environmental laws and regulations.***

We are subject to avariety of laws, rules and regulations in the United States related to theuse, storage, handling, discharge and disposal of certain chemical materialssuch as isocyanates, alcohols, dimethylacetamide, and glycols used in ourresearch and manufacturing process. Any of those regulations could require usto acquire expensive equipment or to incur substantial other expenses to complywith them. If we incur substantial additional expenses, product costs couldsignificantly increase. Our failure to comply with present or futureenvironmental laws, rules and regulations could result in fines,suspension of production or cessation of operations.

***Ifwe are unable to complete our assessments as to the adequacy of our internalcontrols over financial reporting as required by Section 404 of theSarbanes-Oxley Act of 2002, investors could lose confidence in the reliabilityof our financial statements, which could result in a decrease in the value ofour common stock.***

As directed by Section 404of the Sarbanes-Oxley Act of 2002, the Securities and Exchange Commissionadopted rules requiring public companies to include a report of managementon the company’s internal control over financial reporting in their annualreports on Form 10-K. This report is required to contain anassessment by management of the effectiveness of such company’s internalcontrols over financial reporting. In addition, the public accounting firmauditing a public company’s financial statements must attest to and report onmanagement’s assessment of the effectiveness of the company’s internal controlsover financial reporting. While we are expending significant resources indeveloping the necessary documentation and testing procedures required by Section 404,there is a risk that we will not comply with all of the requirements imposed bySection 404. If we fail to implement required new or improved controls, wemay be unable to comply with the requirements of Section 404 in a timelymanner. This could result in an adverse reaction in the financial markets dueto a loss of confidence in the reliability of our financial statements, whichcould cause the market price of our common stock to decline and make it moredifficult for us to finance our operations.

Under current rules, theCompany is required to comply with the requirements of Section 404 by March 31,2007, provided that our market capitalization is greater than $75 million at September 30,2006. If our market capitalization is below $75 million, we will be required tocomply with the requirements at March 31, 2008.

**RisksRelated to Competition**

The medical deviceindustry in general, and the market for products for use in cardiovascularsurgery in particular, is intensely competitive and characterized by rapidinnovation and technological advances. Product differentiation and performance,client service, reliability, cost and ease of use are important competitiveconsiderations in the medical device industry. The Company expects that thecurrent high levels of competition and technological change in the medicaldevice industry in general, and the cardiovascular surgery products industry inparticular, will continue to increase. Several companies offer devices, whichcompete with devices manufactured by Gish, including Maquet, COBECardiovascular, a division of Sorin Biomedica, Terumo, Medtronic, Inc. andStryker Surgical. Most of the Company’s competitors have longer operatinghistories and significantly greater financial, technical, research, marketing,sales, distribution and other resources than the Company. In addition, theCompany’s competitors have greater name recognition than the Company andfrequently offer discounts as a competitive tactic. There can be no assurancethat the Company’s current competitors or potential future competitors will notsucceed in developing or marketing technologies and products that are moreeffective or commercially attractive than those that have been and are beingdeveloped by the Company or that would render the Company’s technologies andproducts obsolete or noncompetitive, or that such companies will not succeed inobtaining regulatory approval for, introducing or commercializing any suchproducts prior to the Company. Any of the above competitive developments couldhave a material adverse effect on the Company’s business, financial conditionand results of operations.

**RisksRelated to Pricing Pressure**

CardioTech facesaggressive cost-containment pressures from governmental agencies and thirdparty payors. There can be no assurances that CardioTech will be able tomaintain current prices in the face of continuing pricing pressures. Over time,the average price for CardioTech’s products may decline as the markets forthese products become more competitive. Any material reduction in productprices would negatively affect CardioTech’s gross margin, necessitating acorresponding increase in unit sales to maintain net sales.

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**RisksRelated to Our Dependence on International Sales**

International revenuesaccounted for approximately 14%, 17% and 15% of the Company’s total net salesin fiscal 2006, 2005 and 2004, respectively. International revenues are subjectto a number of inherent risks, including the impact of possible recessionaryenvironments in economies outside the U.S., unexpected changes in regulatoryrequirements and fluctuations in exchange rates of local currencies in marketswhere the Company sells its products. While the Company denominates all of itsinternational sales in U.S. dollars, a relative strengthening in the U.S.dollar would increase the effective cost of the Company’s products tointernational customers. The foregoing factors could reduce international salesof the Company’s products and could have a material adverse effect on theCompany’s business, financial condition and results of operations.

**RisksRelated to Our Securities**

***Ourstock price is volatile.***

The market price of ourcommon stock has fluctuated significantly to date. In the past fiscal year, ourstock price ranged from $1.69 to $3.70. The future market price of our commonstock may also fluctuate significantly due to:

·                  variationsin our actual or expected quarterly operating results;

·                  announcementsor introductions of new products;

·                  resultsof clinical trials;

·                  technologicalinnovations by our competitors or development setbacks by us;

·                  thecommencement or adverse outcome of litigation;

·                  changesin analysts’ estimates of our performance or changes in analysts’ forecastsregarding our industry, competitors or customers;

·                  announcementsof acquisition or acquisition transactions; or

·                  generaleconomic and market conditions.

In addition, the stockmarket in recent years has experienced extreme price and volume fluctuationsthat have affected the market prices of many medical and biotechnologycompanies. These fluctuations have often been unrelated or disproportionate tothe operating performance of companies in our industry, and could harm the marketprice of our common stock.

***Additionalauthorized shares of our common stock and preferred stock available forissuance may adversely affect the market.***

We are authorized toissue 50,000,000 shares of our common stock. As of March 31, 2006, therewere 19,796,833 shares of common stock issued and outstanding. However, thetotal number of shares of our common stock issued and outstanding does notinclude shares reserved in anticipation of the exercise of options and warrants.As of March 31, 2006, we had outstanding stock options and warrants ofapproximately 7,091,611 shares of our common stock, the exercise price of whichrange between $0.50 per share to $5.40 per share, and we have reserved sharesof our common stock for issuance in connection with the potential exercisethereof. To the extent such options, warrants or additional investment rightsare exercised; the holders of our common stock will experience further dilution.Stockholders will also experience dilution upon the exercise of options grantedunder our stock option plans. In addition, in the event that any futurefinancing or consideration for a future acquisition, should be in the form of,be convertible into or exchangeable for, equity securities investors willexperience additional dilution.

The exercise of theoutstanding derivative securities will reduce the percentage of common stockheld by our current stockholders. Further, the terms on which we could obtainadditional capital during the life of the derivative securities may be adverselyaffected, and it should be expected that the holders of the derivativesecurities would exercise them at a time when we would be able to obtain equitycapital on terms more favorable than those provided for by such derivativesecurities. As a result, any issuance of additional shares of common stock maycause our current stockholders to suffer significant dilution which mayadversely affect the market. In addition to the above referenced shares ofcommon stock which may be issued without stockholder approval, we have5,000,000 shares of authorized preferred stock, the terms of which may be fixedby our Board, of which 500,000 preferred shares were previously issued, butnone are currently outstanding. While we have no present plans to issue anyadditional shares of preferred stock, our Board has the authority, withoutstockholder approval, to create and issue one or more series 

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of such preferred stock and to determine the voting,dividend and other rights of holders of such preferred stock. The issuance ofany of such series of preferred stock may have an adverse effect on the holdersof common stock.

*Shareseligible for future sale may adversely affect the market.*

From time to time,certain of our stockholders may be eligible to sell all or some of their sharesof common stock by means of ordinary brokerage transactions in the open marketpursuant to Rule 144, promulgated under the Securities Act, subject tocertain limitations. In general, pursuant to Rule 144, a stockholder (orstockholders whose shares are aggregated) who has satisfied a one year holdingperiod may, under certain circumstances, sell within any three month period anumber of securities which does not exceed the greater of 1% of the thenoutstanding shares of common stock or the average weekly trading volume of theclass during the four calendar weeks prior to such sale. Rule 144 alsopermits, under certain circumstances, the sale of securities, without anylimitation, by our stockholders that are non-affiliates that have satisfied atwo year holding period. Any substantial sale of our common stock pursuant to Rule 144or pursuant to any resale prospectus may have material adverse effect on themarket price of our securities.

*Thereis a limitation on director and officer liability.*

As permitted byMassachusetts law, our Restated Articles of Organization limit the liability ofour directors for monetary damages for breach of a director’s fiduciary dutyexcept for liability in certain instances. As a result of our charter provisionand Massachusetts law, stockholders may have limited rights to recover againstdirectors for breach of fiduciary duty. In addition, our bylaws provide that weshall indemnify our directors, officers, employees and agents if such personsacted in good faith and reasoned that their conduct was in our best interest.

*Theanti-takeover provisions of our Restated Articles of Organization and of theMassachusetts corporation law may delay, defer or prevent a change of control.*

Our board of directorshas the authority to issue up to 4,500,000 shares of preferred stock and todetermine the price, rights, preferences and privileges and restrictions,including voting rights, of those shares without any further vote or action byour stockholders. The rights of the holders of common stock will be subject to,and may be harmed by, the rights of the holders of any shares of preferredstock that may be issued in the future. The issuance of preferred stock maydelay, defer or prevent a change in control because the terms of any issuedpreferred stock could potentially prohibit our consummation of any acquisition,reorganization, sale of substantially all of our assets, liquidation or otherextraordinary corporate transaction, without the approval of the holders of theoutstanding shares of preferred stock. In addition, the issuance of preferredstock could have a dilutive effect on our stockholders.

Our stockholders mustgive substantial advance notice prior to the relevant meeting to nominate acandidate for director or present a proposal to our stockholders at a meeting. Thesenotice requirements could inhibit a takeover by delaying stockholder action. Inaddition, our bylaws and Massachusetts law provide for staggered board memberswith each member elected for three years. In addition, directors may be removedby stockholders only for cause and by a vote of 80% of the stock.

**Risk ofMarket Withdrawal or Product Recall**

Complex medical devices,such as the Company’s products, can experience performance problems in thefield that require review and possible corrective action by the manufacturer. Similarto many other medical device manufacturers, the Company periodically receivesreports from users of its products relating to performance difficulties theyhave encountered. During the third quarter of fiscal 2006, the Company recordeda $240,000 provision for a voluntary recall of certain cardiopulmonary products.The Company expects that it will continue to receive customer reports regardingthe performance and use of its products. Furthermore, there can be no assurancethat component failures, manufacturing errors or design defects that couldresult in an unsafe condition or injury to the patient will not occur. If anysuch failures or defects were deemed serious, the Company could be required towithdraw or recall products, which could result in significant costs to theCompany. There can be no assurance that market withdrawals or product recallswill not occur in the future. Any future product problems could result inmarket withdrawals or recalls of products, which could have a material adverseeffect on the Company’s business, financial condition or results of operations.

There can be no assurancethat the Company will be able to successfully take corrective actions ifrequired, nor can there be any assurance that any such corrective actions willnot force the Company to incur significant costs. In addition, there can be noassurance any future recalls will not cause the Company to face increasingscrutiny from its customers, which could cause the Company to lose market shareor incur substantial costs in order to maintain existing market share. We donot currently carry recall insurance and we may be subject to significantrecall costs in the event of a recall.

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**RisksAssociated with Healthcare Reform Proposals**

Political,economical and regulatory influences are subjecting the healthcare industry inthe United States to fundamental change. Potential reforms proposed over thelast several years have included mandated basic healthcare benefits, controlson healthcare spending through limitations on the growth of private healthinsurance premiums and Medicare and Medicaid spending, the creation of largeinsurance purchasing groups and fundamental changes in the healthcare deliverysystem. In addition, some states in which the Company operates are alsoconsidering various healthcare reform proposals. The Company anticipates thatfederal and state governments will continue to review and assess alternativehealthcare delivery systems and payment methodologies and public debate ofthese issues will likely continue in the future. Due to uncertainties regardingthe ultimate features of reform initiatives and their enactment andimplementation, the Company cannot predict which, if any, of such reform proposalswill be adopted, when they may be adopted or what impact they may have on theCompany, and there can be no assurance that the adoption of reform proposalswill not have a material adverse effect on the Company’s business, operatingresults or financial condition. In addition, the actual announcement of reformproposals and the investment community’s reaction to such proposals, as well asannouncements by competitors and third-party payors of their strategies torespond to such initiatives, could produce volatility in the trading and marketprice of the Company’s common stock.

**Item 1B.**                 Unresolved StaffComments

None.

**Item 2.**                          Descriptionof Properties

TheCompany’s headquarters are located in an approximately 27,000 square footbuilding and underlying land located at 229 Andover Street, Wilmington,MA, purchased for $1,750,000 in cash. The current corporate and biomaterialsmanufacturing operations are also located in this building.

TheCompany also leases approximately 16,000 square feet in Plymouth, Minnesotaunder a lease which expires April 2009. Within this facility, the Companyhas constructed a Class 10,000 clean room for the assembly of itsproducts.

TheCompany’s California office and manufacturing facilities are located in RanchoSanta Margarita, California in a building containing approximately 52,000square feet of space under a lease, which expires in February 2011. Withinthis facility, the Company has constructed a Class 10,000 clean room forthe assembly of its products. The Company’s finished goods storage facility islocated in Irvine, California in a building containing approximately 23,000square feet of space under a lease, which expires in January 2010.

**Item 3.**                          LegalProceedings

TheCompany is not a party to any legal proceedings, other than ordinary routinelitigation incidental to its business, which the Company believes will not havea material affect on its financial position or results of operations.

**Item 4.**                          Submissionof Matters to a Vote of Security Holders

**None.**

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**PART II**

**Item 5.**                          MarketInformation for Common Equity and Related Stockholder Matters

The common stock trades on the American Stock Exchangeunder the symbol “CTE.”  The followingtable sets forth the high and low sales prices of the common stock for each ofthe last two fiscal years, as reported on the American Stock Exchange.

|             | ** ** | **Fiscal Year 2006** | ** ** |
|-------------|------------|--------------------------------|------------|
| ** **  | ** ** | **High**                       | ** ** | **Low** | ** ** |
| 4th Quarter |       | $                              | 3.60       |   | $ | 2.30 |   |
| 3rd Quarter |       | 2.82                           |       | 1.93 |   |
| 2nd Quarter |       | 3.70                           |       | 1.70 |   |
| 1st Quarter |       | 2.15                           |       | 1.69 |   |
|             |            |                                |            |  |  |  |  |

 

|             | ** ** | **Fiscal Year 2005** | ** ** |
|-------------|------------|--------------------------------|------------|
| ** **  | ** ** | **High**                       | ** ** | **Low** | ** ** |
| 4th Quarter |       | $                              | 2.99       |   | $ | 1.80 |   |
| 3rd Quarter |       | 3.10                           |       | 2.40 |   |
| 2nd Quarter |       | 4.21                           |       | 2.55 |   |
| 1st Quarter |       | 5.20                           |       | 3.20 |   |
|             |            |                                |            |  |  |  |  |

 

Asof June 16, 2006, there were approximately 413 stockholders of record and7,886 additional beneficial stockholders (stockholders holding common stock inbrokerage accounts). The last sale price as reported by the American StockExchange on June 15, 2006, was $2.11. The Company has never paid a cashdividend on its common stock and does not anticipate the payment of cashdividends in the foreseeable future.

**Securities Authorizedfor Issuance under Equity Compensation Plans as of the End of Fiscal 2006Equity Compensation Plan Information**
| **Plan Category**                                    | ** ** | ** ** | ** ** | **Number of securities to  be issued upon exercise  of outstanding options,  warrants and rights (a)** | ** ** | **Weighted average  exercise price of  outstanding options,  warrants and rights (b)** | ** ** | **Number of securities  remaining available for  future issuance (c)** | ** ** |
|-----------------------------------------------------------|------------|------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------|------------|
| Equity  compensation plans approved by stockholders  |       | 5,825,880  | (1)        | $2.19                                                                                                                                                         |       | 965,954                                                                                                                   |       |
| Equity  compensation plans not approved by stockholders   |       | 385,000    |       | $2.46                                                                                                                                                         |       | —                                                                                                                    |       |
| Total                                                     |       | 6,210,880  |       | $2.21                                                                                                                                                         |       | 965,954                                                                                                                   |       |

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(1)          Thistotal includes shares to be issued upon exercise of outstanding options undertwo equity compensation plans that have been approved by CardioTech’sstockholders (i.e.,the 1996 Plan and the 2003 Plan).

**Recent Sales of Unregistered Securities:**

Therewere no sales of unregistered securities in fiscal 2006 and 2004.

Infiscal 2005, the Company sold the following unregistered securities that werenot reported on Form 8-K:

On December 2004,the Company issued 1,139,586 shares of its common stock at $2.40 per share in aprivate placement receiving approximately $2,735,000 in gross proceeds, lessplacement agent fees and related transaction costs of approximately $314,000.

In February 2005,CardioTech contributed 308,642 shares of its common stock to CorNova, Inc.to participate 

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in the funding of CorNova. As the issuance representeda transaction by an issuer not involving any public offering, the shares wereissued pursuant to the private offering exemption set forth in Section 4(2) ofthe Securities Act of 1933.

**StockRepurchase Plan**

***In June 2001, the Board of Directors authorized thepurchase of up to 250,000 shares of the Company’s common stock, of which174,087 shares have been purchased as of March 31, 2006. In June 2004,the Board of Directors authorized the purchase of up to 500,000 additionalshares of the Company’s common stock. The Company announced that purchases maybe made from time-to-time in the open market, privately negotiatedtransactions, block transactions or otherwise, at times and prices deemedappropriate by management.***

***The following table summarizes information regarding sharespurchased during the quarter ended March 31, 2006.***
| **Quarter Ended**   | ** ** | ** ** | ** ** | **Total number  of shares  purchased** | ** ** | **Average  price paid  per share** | ** ** | **Total number of  shares purchased  as part of publicly  announced plans** | ** ** | **Maximum number  of shares that may  be purchased  under the plans** | ** ** |
|--------------------------|------------|------------|------------|--------------------------------------------------|------------|----------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------|------------|
| June 30,  2005      |       | 1,800      |       | $1.86                                            |       | 1,800                                        |       |                                                                                                           |       |
| September 30,  2005 |       | 1,500      |       | $1.89                                            |       | 1,500                                        |       |                                                                                                           |       |
| December 31,  2005  |       | 800        |       | $2.36                                            |       | 800                                          |       |                                                                                                           |       |
| March 31,  2006     |       | 1,310      |       | $3.09                                            |       | 1,310                                        |       |                                                                                                           |       |
| Total                    |       | 5,410      |       | $2.24                                            |       | 5,410                                        |       | 575,913                                                                                                        |       |

 

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** **

**Item 6.**                       SelectedConsolidated Financial Data

The following selectedconsolidated financial data should be read in conjunction with the auditedconsolidated financial statements and notes thereto and management’s discussionand analysis of financial condition and results of operations includedelsewhere in this Annual Report on Form 10-K. The balance sheet dataas of March 31, 2006 and 2005 and the statements of operations data forthe three years ended March 31, 2006 have been derived from the auditedconsolidated financial statements for such years, included elsewhere in thisAnnual Report on Form 10-K. The balance sheet data as of March 31,2004, 2003, and 2002 and the statements of operations data for the two yearsended March 31, 2003 have been derived from the audited consolidatedfinancial statements for such years, not included in this Annual Report on Form 10-K.Furthermore, results for the year ended March 31, 2006 are not necessarilyindicative of results that may be expected for our next fiscal year or anyother future period. You should read carefully the financial statementsincluded in this Form 10-K, including the notes to the financialstatements and “Management’s Discussion and Analysis of Financial Condition andResults of Operations.”  The selectedfinancial data in this section are not intended to replace the financialstatements.
| ** **                                                                   | ** ** | **For the Fiscal Years Ended March 31,** | ** ** |
|------------------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|
| ***(in thousands, except per share data)***         | ** ** | **2006**                                                               | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| **Consolidated Statement of  Operations Data:**                              | ** ** | ** **                                                             | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenues:                                                                    |       |                                                                   |       |   |   |   |   |   |   |   |   |
| Product sales                                                                |       | $                                                                      | 21,404     |   | $ | 21,067 |   | $ | 21,323 |   | $ | 2,880 |   | $ | 2,550 |   |
| Research grants and contracts                                                |       | —                                                                 |       | — |   | — |   | 88 |   | 278 |   |
| Royalties                                                                    |       | 977                                                                    |       | 774 |   | 476 |   | 426 |   | 392 |   |
|                                                                         |       | 22,381                                                                 |       | 21,841 |   | 21,799 |   | 3,394 |   | 3,220 |   |
| Cost of sales                                                                |       | 18,304                                                                 |       | 15,645 |   | 15,670 |   | 2,062 |   | 1,726 |   |
| Gross margin                                                                 |       | 4,077                                                                  |       | 6,196 |   | 6,129 |   | 1,332 |   | 1,494 |   |
| Operating expenses:                                                          |       |                                                                   |       |   |   |   |   |   |   |   |   |
| Cost of research grants and contracts                                        |       | —                                                                 |       | — |   | — |   | 61 |   | 228 |   |
| Research and development, regulatory and engineering                         |       | 1,385                                                                  |       | 1,258 |   | 1,065 |   | 313 |   | 273 |   |
| Selling, general and administrative                                          |       | 6,162                                                                  |       | 6,015 |   | 5,655 |   | 1,946 |   | 2,284 |   |
| Impairment of goodwill                                                       |       | 1,152                                                                  |       | — |   | — |   | — |   | — |   |
| Severance payment                                                            |       | —                                                                 |       | — |   | 372 |   | — |   | — |   |
| Non-cash compensation & research contract  expense                  |       | 193                                                                    |       | 78 |   | 1,171 |   | 19 |   | 786 |   |
| CarTika acquisition expenses                                                 |       | —                                                                 |       | 333 |   | — |   | — |   | — |   |
|                                                                         |       | 8,892                                                                  |       | 7,684 |   | 8,263 |   | 2,339 |   | 3,571 |   |
| Loss from  operations                                                        |       | (4,815                                                                 | )          | (1,488 | ) | (2,134 | ) | (1,007 | ) | (2,077 | ) |
| Interest and  other income and expense, net                                  |       | 146                                                                    |       | 6 |   | 620 |   | 44 |   | 106 |   |
| Equity in net  loss of CorNova, Inc.                                    |       | (400                                                                   | )          | (113 | ) | (1 | ) | — |   | — |   |
| Net loss                                                                     |       | $                                                                      | (5,069     | ) | $ | (1,595 | ) | $ | (1,515 | ) | $ | (963 | ) | $ | (1,971 | ) |
|                                                                         |       |                                                                   |       |   |   |   |   |   |   |   |   |
| Net loss per  common share, basic and diluted                                |       | $                                                                      | (0.26      | ) | $ | (0.09 | ) | $ | (0.10 | ) | $ | (0.11 | ) | $ | (0.23 | ) |
|                                                                         |       |                                                                   |       |   |   |   |   |   |   |   |   |
| Shares used in  computing net loss per common share, basic and diluted  |       | 19,451                                                                 |       | 18,023 |   | 15,421 |   | 9,129 |   | 8,621 |   |

 

 
| ** **                            | ** ** | **As of March 31,** | ** ** |
|---------------------------------------|------------|------------------------------------|------------|
| ***(in thousands)***             | ** ** | **2006**                           | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| **Consolidated Balance Sheet  Data:** | ** ** | ** **                         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash and cash  equivalents            |       | $                                  | 6,841      |   | $ | 7,469 |   | $ | 7,117 |   | $ | 2,939 |   | $ | 4,093 |   |
| Current assets                        |       | 14,953                             |       | 16,096 |   | 15,338 |   | 3,800 |   | 4,728 |   |
| Working capital                       |       | 12,133                             |       | 13,517 |   | 12,051 |   | 2,659 |   | 3,608 |   |
| Total assets                          |       | 20,451                             |       | 23,762 |   | 22,875 |   | 5,898 |   | 6,554 |   |
| Revolving line  of credit             |       | —                             |       | — |   | 730 |   | — |   | — |   |
| Total stockholders’  equity      |       | 17,502                             |       | 21,010 |   | 19,368 |   | 4,757 |   | 5,434 |   |
|                                       |            |                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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** **

**Item 7.**                       Management’sDiscussion and Analysis or Plan of Operation

**Future Operating Results**

This Annual Report on Form 10-Kcontains certain forward-looking statements that are based on currentexpectations. In light of the important factors that can materially affectresults, including those set forth in this paragraph and below, the inclusionof forward-looking information herein should not be regarded as arepresentation by the Company or any other person that the objectives or plansof the Company will be achieved. The Company may encounter competitive,technological, financial and business challenges making it more difficult thanexpected to continue to develop and market its products; the market may notaccept the Company’s existing and future products;  the Company may not be able to retain itscustomers; the Company may be unable to retain existing key managementpersonnel; and there may be other material adverse changes in the Company’soperations or business. Certain important factors affecting the forward-lookingstatements made herein include, but are not limited to (i) continueddownward pricing pressures in the Company’s targeted markets, (ii) thecontinued acquisition of the Company’s customers by certain of its competitors,and (iii) continued periods of net losses, which could require the Companyto find additional sources of financing to fund operations, implement itsfinancial and business strategies, meet anticipated capital expenditures andfund research and development costs. Assumptions relating to budgeting,marketing, product development and other management decisions are subjective inmany respects and thus susceptible to interpretations and periodic revisionsbased on actual experience and business developments, the impact of which maycause the Company to alter its marketing, capital expenditure or other budgets,which may in turn affect the Company’s financial position and results ofoperations. The reader is therefore cautioned not to place undue reliance onforward-looking statements contained herein, which speak solely as of the dateof this Form 10-K. For further information you are encouraged toreview CardioTech’s filings with the Securities and Exchange Commission,including its Quarterly Reports on Form 10-Q for the periods ended June 30,2005, September 30, 2005 and December 31, 2005. The Company assumesno responsibility to update any forward-looking statements as a result of newinformation, future events, or otherwise.

**Overview**

The Company has oneoperating segment, medical device manufacturing and sales, and operates asthree divisions; (i) biomaterials, (ii) private label medical devicemanufacturing and (iii) cardiopulmonary products. The Company is a medicaldevice company that develops, manufactures and sells advanced products for thetreatment of cardiovascular and diseases.

*Critical Accounting Policies*

Oursignificant accounting policies are summarized in Note A to our consolidatedfinancial statements. However, certain of our accounting policies require theapplication of significant judgment by our management, and such judgments arereflected in the amounts reported in our consolidated financial statements. Inapplying these policies, our management uses its judgment to determine theappropriate assumptions to be used in the determination of estimates. Thoseestimates are based on our historical experience, terms of existing contracts,our observance of market trends, information provided by our strategic partnersand information available from other outside sources, as appropriate. Actualresults may differ significantly from the estimates contained in ourconsolidated financial statements. Our critical accounting policies are asfollows:

·       *Revenue Recognition.*The Company recognizes revenue inaccordance with Staff Accounting Bulletin (“SAB”) No. 104, “RevenueRecognition in Financial Statements.” The Company recognizes revenue from product sales upon shipment,provided that a purchase order has been received or a contract has beenexecuted, there are no uncertainties regarding customer acceptance, the salesprice is fixed or determinable and collection is deemed probable. Ifuncertainties regarding customer acceptance exist, the Company recognizesrevenue when those uncertainties are resolved and title has been transferred tothe customer. Amounts collected or billed prior to satisfying the above revenuerecognition criteria are recorded as deferred revenue. The Company alsoreceives license and royalty fees for the use of its proprietary biomaterials. CardioTechrecognizes these fees as revenue in accordance with the terms of the contracts.Contracted product design and development projects are recognized on a time andmaterials basis as services are performed.

·       *AccountsReceivable Valuation.*We perform various analyses to evaluateaccounts receivable balances and record an allowance for bad debts based on theestimated collectibility of the accounts such that the amounts reflectestimated net realizable value. If actual uncollectible amounts significantlyexceed the estimated allowance, the Company’s operating results would besignificantly and adversely affected.

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·       *InventoryValuation.* We value our inventory at the lower of our actual cost orthe current estimated market value. We regularly review inventory quantities onhand and inventory commitments with suppliers and record a provision for excessand obsolete inventory based primarily on our historical usage for the priortwelve to twenty-four month period. Although we make every effort to ensure theaccuracy of our forecasts of future product demand, any significantunanticipated change in demand or technological developments could have asignificant impact on the value of our inventory and our reported operating results.As further described below, a decision by a key customer (the “End User”)resulted as of March 31, 2006 in an impairment of $556,000 related tocustom inventory held by the Company related to the End User’s products, whichwas recorded in the fourth quarter of fiscal 2006.

·       *Intangibles.*Our long-lived assets include intangible assetsand goodwill. In assessing the recoverability of our intangible assets andgoodwill, we must make assumptions in determining the fair value of the assetby estimating future cash flows and considering other factors, including oursignificant changes in the manner or use of the assets, or negative industryreports or economic conditions. If those estimates or their related assumptionschange in the future, we may be required to record impairment charges for thoseassets. Under the provisions of Statement of Financial Accounting Standards, orSFAS No. 142, “Goodwill and Other Intangible Assets,” we are required totest our intangible assets for impairment on a periodic basis thereafter. Duringthe quarter ended March 31, 2006 the Company tested its intangible assetsfor impairment and based on the results of the first step of the goodwillimpairment test, the Company determined that the fair value of goodwill of itscardiopulmonary and private-label medical device manufacturing divisions wasless the respective carrying amounts and, therefore, goodwill impairmentexisted as of March 31, 2006. As a result, the second step of the goodwillimpairment test was completed, and a charge of $1,152,000 was recorded forthe  impairment of goodwill at thedivisions. The company will be required to continue to perform a goodwillimpairment test on an annual basis, or more frequently if indicators of impairmentexist, and the next test is scheduled during the quarter ending March 31,2007.

**Results of Operations**

*Fiscal Years Ended March 31, 2006 vs. March 31,2005*

*Revenues*

The following tablepresents revenues and the change in revenues for the years ended March 31,
| ***(in thousands)*** | ** ** | **2006**   | ** ** | **% of   Revenues** | ** ** | **2005**   | ** ** | **% of   Revenues** | ** ** |
|---------------------------|------------|------------|------------|-------------------------------|------------|------------|------------|-------------------------------|------------|
| Revenues:                 | ** ** | ** ** |       |                          | ** ** | ** ** | ** ** | ** **                    | ** ** |
| Product sales             |       | $          | 21,404     |                          | 95.6       | %          | $          | 21,067                        |       | 96.5 | % |
| Royalties                 |       | 977        |       | 4.4                           | %          | 774        |       | 3.5                           | %          |
|                      |       | $          | 22,381     |                          | 100.0      | %          | $          | 21,841                        |       | 100.0 | % |

 

The following tablepresents product sales by group expressed as a percentage of total productsales for the fiscal years ended March 31,
| ** **                                 | ** ** | **2006**           | ** ** | **2005**                 | ** ** |
|--------------------------------------------|------------|--------------------|------------|--------------------------|------------|
| ***(in thousands)***                       | ** ** | **Product  sales** | ** ** | **% of  Product  sales** | ** ** | **Product  sales** | ** ** | **% of  Product  sales** | ** ** |
| Medical devices                            |       | $                  | 20,411     |                     | 95.4       | % | $ | 19,530 |   | 92.7 | % |
| Contracted  product design and development |       | 993                |       | 4.6                      | %          | 1,537 |   | 7.3 | % |
|                                       |       | $                  | 21,404     |                     | 100.0      | % | $ | 21,067 |   | 100.0 | % |

 

Medical device revenuesfor the fiscal year ended March 31, 2006 were $20,411,000 as compared to$19,530,000 for the comparable prior year period, an increase of $881,000, or4.5%. Medical devices are primarily composed of cardiopulmonary bypassproducts, private-label products, and biomaterials typically used forimplantable devices. Medical device revenues increased principally due toincreases in the sales of private label

27

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products (an increase of approximately $2,021,000),offset in part by decreases in shipments of cardiopulmonary bypass products (adecrease of approximately $1,171,000).

In September 2005,the Company announced that it received FDA approval for certain heparin coatedproducts for the cardiopulmonary bypass surgery market. The Company iscurrently applying for CE Mark in Europe for its heparin coated products. In October 2005,the Company hired a Director of Sales and Marketing-Worldwide, to accelerateproduct sales overseas, primarily in Japan, where the Company generates higheroverall gross margins.

Contracted product designand development revenues for the fiscal year ended March 31, 2006 were$993,000 as compared to $1,537,000 for the comparable prior year period, adecrease of $544,000 or 35.4%. Contracted product design and developmentservices are provided primarily to OEM suppliers and development companies withthe expectation of manufacturing private-label medical devices following thecompletion of these services. The decrease in contracted product design anddevelopment services is a result of a shift towards an increase in themanufacture and shipment of private-label medical device products.

Royalties for the fiscalyears ended March 31, 2006 were $977,000 as compared to $774,000 for thecomparable prior year period, an increase of $203,000 or 26.2%. The Company hasagreements to license its proprietary biomaterial technology to medical devicemanufacturers. Royalties are earned when these manufacturers sell medicaldevices which use the Company’s biomaterials, accordingly, the increase inroyalties during the fiscal year ended March 31, 2006 is a result ofincreased shipments of product by these manufacturers.

*Gross Margin*

The following tablepresents product sales gross margins and gross margin percentages as a percentof the respective product sale category for the years ended March 31,
| ** **                | ** ** | **2006**          | ** ** | **2005**                 | ** ** |
|---------------------------|------------|-------------------|------------|--------------------------|------------|
| ***(in thousands)*** | ** ** | **Gross  Margin** | ** ** | **% Gross  Margin** | ** ** | **Gross  Margin** | ** ** | **% Gross  Margin** | ** ** |
| Product sales             |       | $                 | 3,100      |                     | 14.5       | % | $ | 5,422 |   | 25.7 | % |
|                           |            |                   |            |                          |            |  |  |  |  |  |  |

 

Gross margin on productsales (excluding royalty income) was $3,100,000, or 14.5% as a percentage ofproduct revenue for the fiscal year ended March 31, 2006, as compared to$5,422,000, or 25.7% for the comparable prior year period.

Beginningin fiscal 2005 and continuing into fiscal 2006, the Company started shippingbranded catheter products in its private label business on a purchase orderbasis to a major customer (the “Intermediary”), who would then performadditional manufacturing processes and ship these products to the end user (the“End User”). These products were developed previously by the End User who thentransferred manufacturing to the Intermediary. The Intermediary then engagedthe Company to manufacture the products. In March 2006, the End Usersought to directly source products from the Company.

On May 18,2006, the Company was notified by the End User that the End User had decided tocease using the Company for future production. During this time, the End Useralso began an alliance with a competitive supplier of branded catheters.

TheEnd User’s decision in May 2006 was due to concerns about supplyconstraints related to production specifications. The Company has agreed to,and is in process of completing, the following actions in order to provide theEnd User with objective information to decide whether the End User will engagethe Company for future production. First, all products in question by the EndUser will be identified, inspected and/or reworked by the Company  Secondly, the Company will jointly evaluatethese products with the End User so that the End User can determine, in itssole discretion, whether: (i) the Company’s products are now consistentwith the End User’s specifications and (ii) to begin ordering productsfrom the Company.

Asfurther described below, this decision by the End User resulted in animpairment of $556,000 for custom inventory held by the Company at March 31,2006.

The 11.2% decrease ingross margins as a percentage of product revenue for the fiscal year ended March 31,2006 as compared to March 31, 2005 is due to: (i) first-time pilotproduction costs incurred during the year for new

28

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products in the Company’s private-label medical devicemanufacturing division by the Intermediary/End User, (ii) a $556,000impairment of certain custom inventory as of March 31, 2006 associated with the above-described decision by theEnd User to discontinue future purchases, (iii) a change in product mix toa higher percentage of lower margin, private-label products, (iv) increasedraw material costs for the cardiopulmonary products resulting from inflationarypressures on petrochemical-based supplies, and (v) a  $240,000 provision for a voluntary recall ofcertain cardiopulmonary products.

*Research and Development,Regulatory, and Engineering Expenses*

The following tablepresents research and development expenses as a percentage of revenues  for the fiscal years ended March 31,
| ***(in thousands)***                                  | ** ** | **2006** | ** ** | **% of Revenues** | ** ** | **2005** | ** ** | **% of Revenues** | ** ** |
|-------------------------------------------------------|------------|----------|------------|-------------------|------------|----------|------------|-------------------|------------|
| Research and  development, regulatory and engineering |       | $1,385   |       | 6.2               | %          | $1,258   |       | 5.8               | %          |

 

Research and developmentexpenses for the fiscal year ended March 31, 2006 were $1,385,000 ascompared to $1,258,000 for the comparable prior year period, an increase of$127,000 or 10.1%. This increase is primarily a result of the timing ofactivities associated with the development of and clinical efforts associatedwith the CardioPass graft and activities for cardiopulmonary products. CardioTech’sresearch and development efforts are primarily focused on developing itssynthetic vascular graft technologies, including the CardioPass graft, and GishBiocompatible Surface Coating applications. Research and developmentexpenditures consisted primarily of the salaries of  full time employees and related expenses, andare expensed as incurred. In addition, the Company allocates a portion of thesalary and related costs of Michael Szycher, Ph.D., Chairman and CEO, for timespent on research and development activities. These individuals work on avariety of projects, including production support, and the Company believes itis operating at the minimum staffing level to support its operating needs.

Previously, the Companyentered into a two-year consulting agreement with Dr. Ryan, CEO ofCorNova, which provides for a range of payments, in either cash or commonstock, for the achievement of certain milestones related to the manufacturing,commencement of European clinical trials and the receipt of a restricted CEmark of the Company’s CardioPass graft (the “Ryan Consulting Agreement”). Totalpotential payments range from $161,000 to $216,000 based on the timing of themilestone achievements. As part of the agreement, Dr. Ryan has theopportunity to earn up to an additional $41,000 based on the achievement ofcertain milestones related to other products of the Company. For the fiscalyear ended March 31, 2006, several of the contract milestones wereachieved and, accordingly, costs totaling $38,000 related to performance underthis contract have been recognized as a research and development expense. TheCompany has no other long-term research and development commitments.

Research and developmentcosts will increase significantly if the Company enters into EuropeanUnion,  U.S. clinical trials with itsCardioPass graft, or other products.

*Selling, General andAdministrative Expenses*

The following tablepresents selling, general and administrative expenses as a percentage ofrevenues for the fiscal years ended March 31,

 
| ***(in thousands)***            | ** ** | **2006** | ** ** | **% of  Revenues** | ** ** | **2005** | ** ** | **% of  Revenues** | ** ** |
|--------------------------------------|------------|----------|------------|-------------------------|------------|----------|------------|-------------------------|------------|
| Selling, general  and administrative |       | $        | 6,162      |                    | 27.5       | %        | $          | 6,015                   |       | 27.5 | % |
|                                      |            |          |            |                         |            |          |            |                         |            |  |  |

 

Selling, general andadministrative expenses for the fiscal year ended March 31, 2006 were$6,162,000 as compared to $6,015,000 for the comparable prior year period, anincrease of $147,000 or 2.4%.

*Impairment of Goodwill*

In the fourth quarter ofthe fiscal year ended March 31, 2006, the Company completed its annualreview of goodwill and other intangible assets and determined that all goodwillat both its private label medical device manufacturing division andcardiopulmonary products divisions was impaired. As a result of this review,the Company recorded a charge of  $598,000for the  impairment of goodwill relatedto its private-label medical device manufacturing division primarily due to thecurrent cessation of the End User as a customer. In addition, the

29

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Company recorded an additional $554,000 goodwillimpairment charge for its cardiopulmonary business due to continued reduceddemand for these products.

*Non-cash Compensation andResearch Contract Expense*

Non-cash compensation andresearch contract expenses for the fiscal year ended March 31, 2006 were$193,000 as compared to $78,000 for the comparable prior year period, anincrease of $115,000, or 147.4%, primarily due to increase in the number ofoptions granted to outside consultants.

*CarTika Acquisition Expenses*

CarTika acquisitionexpenses for the fiscal year ended March 31, 2005 were $333,000. Theseexpenses related to a potential acquisition in the fiscal year ended March 31,2005 that was not consummated. During the fiscal year ended March 31,2006, there were no other charges to be recognized in connection with thisterminated acquisition.

*Interest and Other Income andExpense*

Interest and other incomeand expense, net for the fiscal year ended March 31, 2006 was $146,000 ascompared to $6,000 for the comparable prior year period, an increase of$140,000. This increase is primarily due to the net $75,000 recovery related totransaction costs incurred and paid in connection with the proposed acquisitionof CarTika Medical, Inc.

*Income Taxes*

As of March 31,2006, the Company had federal and state net operating loss carry forwards ofapproximately $26,915,000 and $20,124,000, respectively, available to offsetfuture taxable income, that expire between 2008 through 2026. Approximately$11,349,000 of the Federal net operating loss carry forwards is subject toannual limitations as a result of the change in control of Gish.

As a result of the aboveactivity, the Company had net losses of $5,069,000 and $1,595,000 in fiscal2006 and 2005, respectively.

*Fiscal Years Ended March 31, 2005 vs. March 31,2004*

The cardiac surgerymarket is the primary market within the medical device industry that theCompany serves. The Company generates revenue from the manufacture and sale ofsingle use, disposable medical devices, from the operation as an outsourcingsource for medical device OEM and development companies, from the manufacture,sale or license of technology of specialized polymer based materials and thesale of wound dressings. Product sales of the Company for fiscal 2005 decreased1% when compared to fiscal 2004, as disposable medical device sales andoutsourcing revenue each decreased, but this decrease was partially offset byan increase in biomaterial revenue.

Productrevenue by product group for the presented periods is as follows:
| ** **                              | ** ** | **Fiscal Year Ended March 31,** | ** ** |
|-----------------------------------------|------------|-----------------------------------------------------|------------|
| ***(in thousands)***               | ** ** | **2005**                                            | ** ** | **2004** | ** ** |
| Sales of medical  devices               |       | $                                                   | 17,435     |   | $ | 17,781 |   |
| Outsourcing  services and manufacturing |       | 2,804                                               |       | 2,966 |   |
| Other revenues                          |       | 828                                                 |       | 576 |   |
|                                    |       | $                                                   | 21,067     |   | $ | 21,323 |   |

 

Royalty revenue increased63% when compared with the prior fiscal year and has the potential forcontinued gradual increase as the Company continues to explore other uses forits patented materials.

Thedecrease in gross margin percentage to 25.7% for fiscal year 2005 from 26.5% infiscal year 2004 relates primarily to an increase of $100,000 to its reservefor slow-moving inventory recorded in December 2004 in its wound dressingoperations and the expensing of initial contract start-up costs for anoutsourcing manufacturing contract in the Company’s fiscal fourth quarter.

30

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| ** **                                            | ** ** | **Fiscal Year Ended March 31,** | ** ** |
|-------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ***(in thousands)***                             | ** ** | **2005**                                            | ** ** | **2004** | ** ** |
| Research and  development, regulatory and engineering |       | $                                                   | 1,258      |   | $ | 1,065 |   |
| Selling and  marketing                                |       | 2,838                                               |       | 2,572 |   |
| General and  administrative                           |       | 3,177                                               |       | 3,083 |   |
| Severance  payment                                    |       | —                                              |       | 372 |   |
| CarTika  acquisition expense                          |       | 333                                                 |       | — |   |
| Noncash  compensation and research contract expense   |       | 78                                                  |       | 1,171 |   |
|                                                  |       | $                                                   | 7,684      |   | $ | 8,263 |   |

 

CardioTech’s research anddevelopment efforts were primarily focused on developing its synthetic vasculargraft technologies and GBS coating applications. Research and development,regulatory and engineering expenditures for the years ended March 31, 2005and 2004 consisted primarily of salaries and related costs (60% in fiscal 2005and 72% in fiscal 2004), and are expensed as incurred. In this income statementcategory, the Company has six full time employees and allocates a portion of Dr. Szycher’ssalary and related costs to this income statement category. These individualswork on a variety of projects, including production support, and the Companybelieves it is operating at the minimum staffing level to support its operatingneeds. The costs related to this minimum level of operations totaled $888,000and $975,000 in fiscal 2005 and 2004, respectively. Expenses for the year endedMarch 31, 2005 compared with the prior year increased due to an increasein CardioPass related expenditures.

The increase in sellingand marketing expenses for the year ended March 31, 2005 compared to theprior year is due primarily to a full year of marketing efforts of the wounddressings ($200,000) and increased outsourcing revenue generation efforts.

The increase in generaland administrative expenses for the year ended March 31, 2004 compared tothe prior year is due to an increase in the Company’s allowance for doubtfulaccounts of $230,000 recorded in December 2004 and a general decrease incosts related to a variety of business activities. The increase in theallowance for doubtful accounts relates to one customer for which the Companyperforms outsourcing services ($80,000) and one customer to which the Companysells disposable medical devices ($150,000).

Effective April 30,2003, the former CEO of Gish resigned from his position. In accordance with hisemployment agreement, he was to receive severance payments equal to two yearsof his base salary, which totaled $360,000. An initial payment of $90,000 wasmade in May 2003 and the remaining amount due was paid in eighteen equalmonthly payments. The full amount of the severance obligation, includingestimated payroll taxes, of $372,000, was recorded as severance payment in April 2003.

For fiscal 2005, theCompany had non-cash compensation expenses of $58,000 related to the grantingof options to purchase 100,000 shares of the Company’s common stock at $3.50per share in payment for  investmentadvisory services and $20,000 related to the acceleration in July 2004 ofvesting of stock options. For fiscal 2004, the Company had a non-cashcompensation expense of $1,171,000. These non-cash items were comprised of a$344,000 expense due to warrant modifications for 80,000 shares of commonstock, a $210,000 expense due to the issuance of 40,000 shares of common stockto Implant pursuant to the joint research program on developing a drug-elutingstent and a $92,000 expense for stock options granted to two consultants. Additionally,there was a non-cash expense of $293,000 related to the issuance of 95,000treasury shares to various employees and board members for their effort in theGish transaction and a $232,000 expense related to stock options granted at adiscount to a consultant.

On November 19,2004, the Company entered into a definitive agreement (the “Asset PurchaseAgreement”) to acquire substantially all of the assets and assume certainliabilities of CarTika Medical, Inc., a privately owned medical devicecontract manufacturer headquartered in Plymouth, Minnesota (“CarTika”). As partof the transaction, the Company was to issue consideration to the stockholdersof CarTika consisting of shares of the Company’s common stock, equal in valueto $1,662,000, with the number of shares based upon the fair market value ofthe common stock at the date of closing (“Stock Consideration”), and $4,985,000in cash (“Cash Consideration”). The transaction closing was subject to avariety of closing conditions, including the successful filing of aregistration statement covering the Stock Consideration shares. Because of theprotracted time in obtaining regulatory clearance involving the acquisition, onJune 14, 2005, CarTika terminated the proposed acquisition. The Companyincurred CarTika related acquisition costs totaling $333,000, which have beencharged to expense at March 31, 2005.

31

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The Company had $645,000in other income for fiscal 2004. During fiscal 2004, Credent paid CardioTech$400,000 due to the sale of a controlling interest in Credent pursuant to atechnology and license agreement relating to Chronoflex RC. The payment was netagainst $17,000 of accounts receivable due from Credent and is recorded asother income of $383,000 in the statement of operations. The Company alsorecognized income of $237,000 from the recovery of a previously written offreceivable and $25,000 of rental income.

The Company had netlosses of $1,595,000 and $1,515,000 in fiscal 2005 and 2004, respectively.Included in net losses in fiscal 2004 was an accrual for severance costs of$372,000 for the former president of Gish, non-cash compensation and researchand development expenses of $1,171,000 and other income of $645,000, which includedrepayment of a note previously charged-off and a payment by Credent. Withoutthese charges or credits, net loss for fiscal 2004 would have been $617,000(Adjusted Net Loss). The increase in Adjusted Net Loss of $1,214,000 (Net Lossas Reported of $1,595,000 less $78,000 non-cash compensation expense and$333,000 of CarTika acquisition expenses) for fiscal 2005 compared to AdjustedNet Loss of $617,000 for fiscal 2004 relates primarily to the previouslymentioned increases in operating expenses.

At March 31, 2005,the Company had $24,200,000 and $20,600,000 of Federal and State income tax netoperating loss carryovers, respectively. In fiscal 2005, the Company paidincome taxes totaling $12,000, primarily consisting of required minimum statetax payments.

**Liquidity and Capital Resources**

During the fiscal yearended March 31, 2006, the Company had net cash outflows of $1,683,000 fromoperating activities as compared to net cash outflows of $487,000 for thecomparable prior year period. The $1.2 million increase in net cash outflowsused in operating activities during the fiscal year ended March 31, 2006as compared to the comparable prior year period was primarily a result of:  (i) a larger net loss and (ii) increasein inventories of approximately $626,000 (before the effect of a provision of$640,000 for excess and obsolete inventory) as of March 31, 2006 whencompared to March 31, 2005. Inventories increased primarily due to: (i) increasedshipments of private label products during the year ended March 31, 2006and the need for higher levels of materials and (ii) bulk purchases ofmaterials at favorable pricing for cardiopulmonary bypass products during theyear ended March 31, 2006.

Duringthe fiscal year ended March 31, 2006, the Company issued 543,254 shares ofthe Company’s common stock as a result of the exercise of options, generatingapproximate cash proceeds of $1,246,000. During the year ended March 31,2006, the Company purchased 5,410 shares of its common stock at an approximatecost of $12,105.

Contractual obligationsconsist of the following as of March 31, 2006:
| ** **                   | ** ** | **Payment Due by Period** | ** ** |
|------------------------------|------------|------------------------------------------|------------|
| ***(in thousands)***    | ** ** | **Total**                                | ** ** | **Less than 1  Year** | ** ** | **1 to 3  Years** | ** ** | **3 to 5  Years** | ** ** | **More than  5 Years** | ** ** |
| Operating lease  obligations |       | $                                        | 3,497      |   | $ | 766 |   | $ | 2,286 |   | $ | 445 |   | $ | — |   |
| Purchase  obligations        |       | 1,872                                    |       | 1,872 |   | — |   | — |   | — |   |
|                         |       | $                                        | 5,369      |   | $ | 2,638 |   | $ | 2,286 |   | $ | 445 |   | $ | — |   |

 

Operating lease obligations are for aggregate futureminimum rental payments required under leases for office and manufacturingfacilities in the Rancho Santa Margarita, CA; Irvine, CA; and Plymouth, MN.Purchase obligations primarily represent purchase orders issued for inventoryused in production.

With respect to theExchange and Venture Agreement with CorNova, the Company has no additionalobligation to contribute assets or additional common stock nor to assume anyliabilities or to fund any losses that CorNova may incur.

As of March 31,2006, CardioTech was conducting its operations with approximately $6,841,000 incash and cash 

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equivalents. At March 31, 2006, the Company hadno debt. CardioTech believes its current cash position will be sufficient tofund its working capital and research and development activities for at leastthe next twelve months.

TheCompany’s future growth may depend upon its ability to raise capital to supportresearch and development activities and to market and sell its vascular grafttechnology, specifically the coronary artery bypass graft. CardioTech mayrequire substantial funds for further research and development, futurepre-clinical and clinical trials, regulatory approvals, establishment ofcommercial-scale manufacturing capabilities, and the marketing of its products.CardioTech’s capital requirements depend on numerous factors, including but notlimited to, the progress of its research and development programs; the progressof pre-clinical and clinical testing; the time and costs involved in obtainingregulatory approvals; the cost of filing, prosecuting, defending and enforcingany intellectual property rights; competing technological and marketdevelopments; changes in CardioTech’s development of commercializationactivities and arrangements; and the purchase of additional facilities and capitalequipment.

**Item 7A.**              Quantitative andQualitative Disclosures About Market Risk

Weown certain money market funds that are sensitive to market risks as part ofour investment portfolio. The investment portfolio is used to preserve ourcapital until it is required to fund operations, investing or financingactivities. None of the market-risk sensitive instruments held in ourinvestment portfolio are held for trading purposes. We do not own derivativefinancial instruments in our investment portfolio. We do not believe that theexposure to market risks in our investment portfolio is material.

**Item 8.**                       FinancialStatements and Supplementary Data

The following documents are filed as part of thisreport on Form 10-K
| ** **                                                                                                    | ** ** | **Page**   | ** ** |
|---------------------------------------------------------------------------------------------------------------|------------|------------|------------|
| Report of  Ernst & Young LLP, Independent Registered Public Accounting Firm                          |       | F-1        |       |
| Consolidated  Balance Sheets at March 31, 2006 and 2005                                                  |       | F-2        |       |
| Consolidated  Statements of Operations for the years ended March 31, 2006, 2005 and  2004                |       | F-3        |       |
| Consolidated  Statements of Stockholders’ Equity for the years ended March 31, 2006,  2005 and 2004 |       | F-4        |       |
| Consolidated  Statements of Cash Flows for the years ended March 31, 2006, 2005 and  2004                |       | F-6        |       |
| Notes to Consolidated  Financial Statements                                                                   |       | F-7 - F-23 |       |

 

**Item 9.**                       Changes Inand Disagreements With Accountants on Accounting and Financial Disclosure

None.

**Item 9A.**              Controls andProcedures

(a)          *Evaluation of disclosure controls and procedures.*

TheCompany’s management, including the Chief Executive Officer and Chief FinancialOfficer, conducted an evaluation of the Company’s disclosure controls andprocedures as of March 31, 2006. Based on this evaluation, the ChiefExecutive Officer and Chief Financial Officer have determined that suchcontrols and procedures are effective to ensure that information relating tothe Company, including its consolidated subsidiaries, required to be disclosedin reports that it files or submits under the Securities Exchange Act isrecorded, processed, summarized and reported within the time periods specifiedin the rules and forms of the Securities and Exchange Commission. Therehave been no changes in the Company’s internal controls over financialreporting that were identified during the evaluation that occurred during theCompany’s last fiscal quarter of 2006 that have materially affected, or arereasonably likely to materially affect, the Company’s internal control overfinancial reporting.

**Item 9B.**              Other Information

**None.**

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**PART III**

**Item 10.**                   Directors andExecutive Officers of the Registrant

CardioTech’s Board of Directors is currently comprisedof six directors. The directors and executive officers, their ages andpositions at CardioTech as well as certain biographical information of theseindividuals, are set forth below. The ages of the individuals are provided asof March 31, 2006.
| **Name**                          | ** ** | **Age** | ** ** | **Position**                                                             |
|-----------------------------------|------------|---------|------------|--------------------------------------------------------------------------|
| Michael Szycher, Ph.D.            |       | 67      |       | Chairman of the Board,  President, Chief Executive Officer and Treasurer |
| Eric G. Walters                   |       | 54      |       | Vice President and  Chief Financial Officer                              |
| Michael Adams                     |       | 49      |       | Director, Vice  President of Regulatory Affairs and Business Development |
| Anthony J. Armini,  Ph.D.         |       | 68      |       | Director                                                                 |
| Michael Barretti                  |       | 60      |       | Director                                                                 |
| Jeremiah E. Dorsey                |       | 61      |       | Director                                                                 |
| William J. O’Neill, Jr. |       | 63      |       | Director                                                                 |

 

Dr. MichaelSzycher has been Chairman of the Board, President, Chief Executive Officer andTreasurer of CardioTech since June 1996. From October 1989 untiljoining CardioTech in June 1996, Dr. Szycher served as Chairman of PolyMedicaIndustries, Inc. (“PMI”) and Chief Executive Officer of PMI from November 1990to June 1996, and as a director of PMI from its inception until June 1996.Dr. Szycher is also a director of Implant Sciences Corporation (AMEX: IMX).Dr. Szycher is a recognized international authority on polyurethanes andblood compatible polymers. He is the author of over eighty original researcharticles, and was a pivotal force in the creation of the Medical PlasticsDivision of the SPE. Dr. Szycher is the Editor of five books, “BiocompatiblePolymers, Metals and Composites;” “Synthetic Biomedical Polymers;” “BloodCompatible Materials and Devices: Perspectives Towards the 21st Century;” “HighPerformance Biomaterials: A Comprehensive Guide to Medical/PharmaceuticalApplications;” “Szycher’s Dictionary of Biomaterials and Medical Devices,” andthe acclaimed “Szycher’s Dictionary of Medical Devices.”  He is also Editor-In-Chief of the quarterlyJournal of Biomaterials Applications. Dr. Szycher received a Ph.D. in CardiacPhysiology from Boston University School of Medicine, and an MBA from SuffolkUniversity.

Mr. EricG. Walters has been Vice President and Chief Financial Officer of CardioTechsince October 2005. Prior to joining CardioTech, Mr. Walters from October 2004through September 2005 served as Vice President and Chief FinancialOfficer at Konarka Technologies, Inc., a developer of light-activatedplastic (photovoltaic) material. Prior to joining Konarka, Mr. Waltersserved in various capacities at PolyMedica Corporation during a 13-yearperiod, including Executive Vice President and Chief Financial Officer.Mr. Walters, a CPA, is a Member of the American Institute of CertifiedPublic Accountants, a Fellow of the Massachusetts Society of Certified PublicAccountants, and a Member in Financial Executives International. Mr. Waltersalso serves as a Director and the Chairman of the Audit Committee of the Boardof Directors of MFIC Corporation since November 2005. Mr. Waltersreceived his BS degree from Colgate University and a Certificate in Accountingfrom Bentley College.

Mr. MichaelAdams has been a director of CardioTech since May 1999. On April 1,2006, Mr. Adams joined the Company as its Vice President of RegulatoryAffairs and Business Development. Prior to April 2006, Mr; Adams was theVice President of PLC Systems, Inc. Prior to joining PLC Systems in September 2000,Mr. Adams was Vice President of Assurance Medical, Inc. Prior tojoining Assurance Medical in June 1999, Mr. Adams was the ChiefOperating Officer and Vice President of Regulatory Affairs and QualityAssurance of CardioTech from June 1998 to May 1999. From November 1994through June 1998, Mr. Adams served as the Vice President of CytycCorporation. Mr. Adams received a BS from the University of Massachusetts.

Dr. AnthonyJ. Armini has been a director of CardioTech since August 2000. Dr. Arminihas been the President, Chief Executive Officer, and Chairman of the Board ofDirectors of Implant Science Corporation since 1984. From 1972 to 1984, prior tofounding Implant Sciences, Dr. Armini was Executive Vice President atSpire Corporation. From 1967 to 1972, Dr. Armini was a Senior Scientist atMcDonnell Douglas Corporation. Dr. Armini received his Ph.D. in nuclearphysics from the University of California, Los Angeles in 1967. Dr. Arminiis the author of eleven patents, fifteen patents pending and fourteenpublications in the field of implant technology. Dr. Armini has overthirty years of experience working with cyclotrons and linear accelerators, theproduction and characterization of radioisotopes, and fifteen years experiencewith ion implantation in the medical and semiconductor fields.

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Mr. MichaelBarretti has been a director of CardioTech since January 1998. Mr. Barrettiis the executive in residence and professor of marketing at Suffolk Universityin Boston. Mr. Barretti has been the President of Cool Laser Optics, Inc.,a company which commercializes optical technology specific to the medical laserindustry, since July 1996. From September 1994 to July 1996, Mr. Barrettiwas Vice President of Marketing for Cynosure, Inc., a manufacturer ofmedical and scientific lasers. From June 1987 to September 1994, Mr. Barrettiwas a principal and served as Chief Executive Officer of NorthFleet Management Group,a marketing management firm serving the international medical device industry. FromJanuary 1991 to May 1994, Mr. Barretti also acted as Presidentof Derma-Lase, Inc., the U.S. subsidiary of a Glasgow, Scotland supplierof solid-state laser technologies to the medical field. Mr. Barrettireceived his BA from St. Johns University and an MBA from Suffolk University.

Mr. JeremiahE. Dorsey has been a director of CardioTech since May, 2004. Mr. Dorseyretired in 2002. From 1992 to 2002, Mr. Dorsey was President and ChiefOperating Officer of The West Company (Lionville, PA), a leading supplier ofcomponents to the pharmaceutical, medical device and dental businesses. From1990 to 1992, Mr. Dorsey was President and Chief Executive Officer ofFoster Medical (Waltham, MA), a supplier of hospital equipment. From 1988 to1990, he was President of Towles Housewares Company (Newburyport, MA), and VicePresident and Board Member of J&J Dental Products Company (East Windor,NJ), a world leader in composite materials, dental amalgams, cleaning andpolishing products. Mr. Dorsey received a BA from Assumption College andan MBA from Fairleigh Dickinson University.

Mr. WilliamJ. O’Neill, Jr. has been a director of CardioTech since May 2004.Mr. O’Neill is currently the Dean of the Frank Sawyer School of Managementat Suffolk University in Boston, Massachusetts. Prior to this appointment, Mr. O’Neillspent thirty years (1969-1999) with the Polaroid Corporation, where heheld the positions of Executive Vice President of the Corporation, President ofCorporate Business Development, and Chief Financial Officer. He was also SeniorFinancial Analyst at Ford Motor Company. Mr. O’Neill was a Trustee at theDana Farber Cancer Institute, and is currently a member of the MassachusettsBar Association, a member of the Board of Directors of the Greater BostonChamber of Commerce, and serves on the Board of Directors of Concord Camera. Heearned a BA at Boston College in mathematics, a MBA in finance from Wayne StateUniversity, and a JD from Suffolk University Law School.

***Committees;Attendance***

Meeting Attendance. During the fiscal yearended March 31, 2006, there were 5 meetings of the Board. The variouscommittees of the Board also met a total of 7 times during fiscal 2006. Eachdirector attended in excess of 75% of the total number of meetings of the Boardand of committees of the Board on which he served during fiscal 2006. Inaddition, from time to time, the members of the Board and its committees actedby unanimous written consent pursuant to Massachusetts law.

***Audit Committee***

TheBoard has designated from among its members an Audit Committee, which consistedof Messrs. O’Neill (Chairman) and Barretti and Dr. Armini.Messrs. O’Neill and Barretti and Dr. Armini are independent members.Mr. O’Neill meets the requirements to qualify as a financial expert. TheAudit Committee has the responsibility to ascertain that the Company’sfinancial statements reflect fairly the financial condition and operatingresults of the Company and to appraise the soundness, adequacy and applicationof accounting and operating controls. The Audit Committee recommends theindependent auditors to the Board, reviews the scope of the audit functions ofthe independent auditors and reviews the audit reports. The Audit Committeeheld a meeting each quarter during fiscal 2006. The responsibilities of theAudit Committee are outlined in a written charter, which was included as AnnexA of the Proxy Statement for the 2004 shareholder meeting.

***CompensationCommittee***

TheCompensation Committee, which met 2 times during fiscal 2006, had threemembers, Messrs. Barretti, Dorsey and Adams (Chairman). In April 2006,Mr. Adams joined the Company as Vice President of Regulatory Affairs andBusiness Development, continued as a Director and resigned from theCompensation Committee. At that time, the Compensation Committee became Mr. Barretti(Chairman), Mr. Dorsey and Dr. Armini. The Compensation Committeereviews, approves and makes recommendations on the Company’s compensation policies,practices and procedures to ensure that legal and fiduciary responsibilities ofthe Board are carried out and that such policies, practices and procedurescontribute to the success of the Company. The Compensation Committeeadministers the 1996 Plan and the 2003 Plan. In June 2006, theCompensation Committee approved a written charter, which is included as Exhibit 99.1of this Annual Report on Form 10-K.

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***NominatingCommittee***

TheNominating Committee, which was established in March 1998 and had onemeeting in fiscal 2006, has three members, Messrs. Dorsey (Chairman)Barretti and Adams. At the time of April 2006 hire, Mr. Adamscontinued as a Director and resigned from the Nominating Committee. TheNominating Committee nominates individuals to serve on the Board. TheNominating Committee considers nominees recommended by Stockholders*.*

***Compensation Committee Interlocks and InsiderParticipation***

Other than Mr. Adams, no person serving on theCompensation Committee at any time during fiscal 2006 was a present or formerofficer or employee of the Company or any of its subsidiaries. During fiscal2006, other than Dr. Szycher, no executive officer of the Company servedas a member of the board of directors or compensation  committee (or other board committeeperforming equivalent functions) of another entity. During fiscal 2006,Dr. Szycher served on the board of directors of Implant SciencesCorporation, one of whose executive officers served on the Company’s Board orCompensation Committee.

***Directors’ Compensation***

CardioTech’spolicy is to pay $750 per meeting compensation to non-employee members of theBoard for attendance at Board meetings, and $1,500 per meeting to CommitteeChairmen. The chairman of the Audit Committee will also receive $1,500 for eachspecial meeting with CardioTech’s Principal Accountants. All non-employeedirectors are reimbursed for travel and other related expenses incurred inattending meetings of the Board. Effective January 1, 2006, thecompensation policy changed. Each of the Company’s independent directors  receives an annual fee of $12,000 pro-ratedand payable quarterly at the beginning of each quarter. The Chairman of theAudit Committee earns an additional annual fee of $5,000, pro-rated and payablequarterly at the beginning of each quarter. Each independent director receives$1,000 for each special meeting and $750 for each meeting of a Board committee.

Directorsare eligible to participate in the 1996 and 2003 Plans. In fiscal 2004,CardioTech granted each Director an option to purchase 10,000 shares of theCompany’s Common Stock and additional 2,500 shares to chairmen of committees. Infiscal 2005, CardioTech granted the chairman of the Audit Committee an optionto purchase 50,000 shares and granted each director an option to purchase30,000 shares. In fiscal 2005, one board member elected to receive stockoptions to purchase 5,000 shares for each Board meeting attended in fiscal 2005in lieu of cash compensation. In fiscal 2006, one board member elected toreceive stock options to purchase 16,459 shares in lieu of cash compensation.

TheCompany has adopted a code of ethics that applies to its chief executiveofficer, chief financial officer, and vice president of finance. The code ofethics is posted on the Company’s website, the address of which iswww.cardiotech-inc.com. The Company intends to include on its website anyamendments to, or waivers from, a provision of its code of ethics that appliesto the Company’s chief executive officer, chief financial officer, or vice presidentof finance that relates to any element of the code of ethics definitionenumerated in Item 406 of Regulation S-K.

**Section 16(a) BeneficialOwnership Reporting Compliance**

Section 16(a) ofthe Securities Exchange Act of 1934 requires our executive officers, directorsand persons who beneficially own more than 10% of a registered class of oursecurities to file reports of ownership and changes in ownership with the SEC. Basedsolely on a review of copies of such forms submitted to CardioTech, we believethat all persons subject to the reporting requirements of Section 16(a) filedsuch reports on a timely basis in fiscal 2006, except as follows. During fiscal2006, Mr. Dorsey received 8 option grants to purchase shares of theCompany and was late in filing all Forms 4 for these option grants.

**Item 11.**                   ExecutiveCompensation

**Summary Compensation Table.**Thefollowing table sets forth the aggregate compensation for services rendered inall capacities during the fiscal years ended March 31, 2006, 2005, and 2004of all persons serving as Chief Executive Officer and all other executiveofficers whose salary and bonus exceed $100,000 (the “Named Executive Officers”).

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|                                                | ** ** | **Annual Compensation** | ** ** | **Long-term Compensation** | ** ** | ** ** | ** ** |
|------------------------------------------------|------------|------------------------------|------------|---------------------------------|------------|------------|------------|
| **Name and Principal Position** | ** ** | **Year**                     | ** ** | **Salary**                      | ** ** | **Bonus**  | ** ** | **Restricted  Stock Awards** | ** ** | **Number of  Securities  Underlying  Options** | ** ** | **All Other  Compensation** | ** ** |
| Michael Szycher, Ph.D. (1)                     |       | 2006                         |       | $                               | 325,000    |       | $          | — |   | — |   | — |   | $ | 5,498 |   |
| Chairman, CEO and Treasurer                    |       | 2005                         |       | $                               | 325,000    |       | $          | — |   | 55,200 |   | 600,000 |   | $ | 4,794 |   |
|                                                |       | 2004                         |       | $                               | 325,000    |       | $          | — |   | — |   | 1,017,330 |   | $ | 8,092 |   |
|                                           |       |                         |       |                            |       |       |       |   |   |   |   |   |   |
| Eric G. Walters  (1) (2)                  |       | 2006                         |       | $                               | 69,231     |       | $          | — |   | — |   | 200,000 |   | $ | 2,498 |   |
| Vice President  and CFO                        |       |                         |       |                            |       |       |       |   |   |   |   |   |   |
|                                           |       |                         |       |                            |       |       |       |   |   |   |   |   |   |
| Leslie M. Taeger (3)                           |       | 2006                         |       | $                               | 94,894     |       | $          | — |   | — |   | — |   | $ | 250 |   |
| CFO                                            |       | 2005                         |       | $                               | 143,507    |       | $          | 15,000 |   | — |   | 150,000 |   | $ | 250 |   |
|                                                |       | 2004                         |       | $                               | 150,470    |       | $          | 50,000 |   | — |   | 100,000 |   | $ | 250 |   |

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(1)             Includespremiums paid by the Company for disability and term life insurance. Premiumspaid in fiscal 2006, 2005 and 2004 for disability and life insurance,respectively, were $1,973, $1,284 and $885 for Dr. Szycher. Premiums paidin fiscal 2006 for disability and life insurance were $671 for Mr. Walters.Personal use of a leased car for Dr. Szycher was $3,525, $3,510 and$6,247, respectively in fiscal 2006, 2005 and 2004. Personal use of a leasedcar for Mr. Walters was $1,827 in fiscal 2006.

(2)             Mr. Walterswas hired by the Company on October 3, 2005 with an annual salary of$150,000. Effective April 3, 2006, his annual salary was adjusted to$175,000.

(3)             Mr. Taegerceased employment with the Company on October 7, 2005.

TheCompany has entered into an employment agreement (the “Employment Agreement”)with Dr. Michael Szycher, pursuant to which said individual serves asChief Executive Officer of the Company. Pursuant to the terms of the EmploymentAgreement, Dr. Szycher is to receive an annual base salary of ThreeHundred and Twenty Five Thousand ($325,000) dollars. Dr. Szycher’s salarywill be reviewed annually by the Board. Additionally, Dr. Szycher may alsobe entitled to receive an annual bonus payment in an amount, if any, to bedetermined by the Compensation Committee of the Board.

Theterm of the Employment Agreement by and between the Company and Dr. Szycheris set to expire on December 31, 2007. After such time, the term of theEmployment Agreement will be deemed to continue on a month-to-month basis ifnot expressly extended while Dr. Szycher remains employed by the Company.Dr. Szycher and CardioTech each have the right to terminate the EmploymentAgreement at any time, with or without cause (as defined in the EmploymentAgreement), upon thirty (30) days prior written notice. In the event thatCardioTech terminates the applicable Employment Agreement without cause, or Dr. Szycherterminates his employment for good reason following a change in control (assuch terms are defined in the Employment Agreement) or CardioTech fails torenew the Employment Agreement within two (2) years following theoccurrence of a change in control, Dr. Szycher will be entitled to receiveseverance equal to 2.99 times his annual base salary at termination. In suchevent, Dr. Szycher will be bound by a noncompete covenant for one (1) yearfollowing termination of his employment.

TheCompany has entered into an employment agreement (the “Walters Agreement”) withEric G. Walters, pursuant to which said individual serves as Vice President andChief Financial Officer of the 

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Company. Pursuant to the terms of the WaltersAgreement, Mr. Walters is to receive an annual base salary of One HundredSeventy Five Thousand ($175,000) dollars. Mr. Walters salary will bereviewed annually by the Board. Additionally, Mr. Walters may also beentitled to receive an annual bonus payment in an amount, if any, to bedetermined by the Compensation Committee of the Board.

Theterm of the Employment Agreement by and between the Company and Mr. Waltersis set to expire on April 1, 2008. After such time, the term of theWalters Agreement will be deemed to continue on a month-to-month basis if notexpressly extended while Mr. Walters remains employed by the Company.Mr. Walters and CardioTech each have the right to terminate the WaltersAgreement at any time, with or without cause (as defined in the EmploymentAgreement), upon thirty (30) days prior written notice. In the event thatCardioTech terminates the applicable Walters Agreement without cause, or Mr. Waltersterminates his employment for good reason following a change in control (assuch terms are defined in the Walters Agreement) or CardioTech fails to renewthe Walters Agreement within two (2) years following the occurrence of achange in control, Mr.. Walters will be entitled to receive severance equal to2.0 times his annual base salary at termination. In such event, Mr. Walterswill be bound by a noncompete covenant for one (1) year followingtermination of his employment.

Thefollowing table sets forth information regarding each stock option grantedduring the fiscal year ended March 31, 2006 to each of the named executiveofficers.

**OptionGrants in Last Fiscal Year**
| **Name**        | ** ** | ** ** | ** ** | **Number of   securities underlying  options granted (1)** | ** ** | **Percent of  total options  granted to  employees in  fiscal year** | ** ** | **Exercise price  per share** | ** ** | **Expiration  Date** | ** ** |
|-----------------|------------|------------|------------|-------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------|------------|-----------------------------------------|------------|----------------------|------------|
| Eric G. Walters |       | 200,000    |       | 27.4                                                                                | %          | $                                                                                             | 2.32       |                                    | 10/3/2015  |                 |
|                 |            |            |            |                                                                                     |            |                                                                                               |            |                                         |            |                      |            |  |

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(1)  The Company granted options to purchase730,834 shares of Common Stock to employees and consultants in the fiscal yearended March 31, 2006. All options were granted at an exercise price pershare equal to the fair market value of the Common Stock on the date of grant,determined by the closing price on the American Stock Exchange on the tradingday immediately preceding the grant date. Options vested on the date of grantand normally expire ten years from the date of the grant.

**AggregatedOption Exercises in Last Fiscal year and Fiscal Year-End Option Values**

The following table provides information regarding thenumber of shares of Common Stock covered by both exercisable and unexercisablestock options held by each of the named executive officers as of March 31,2006 and the values of “in-the-money” options, which values represent thepositive spread between the exercise price of any such option and the fiscalyear-end value of the Common Stock.
| ** **                    | ** ** | **Underlying unexercised  options/SARS at fiscal  year end 2006** | ** ** | **Value of the unexercised  in the money options/SARS  at fiscal year end (1)** | ** ** | **Shares acquired** | ** ** | ** **        | ** ** |
|-------------------------------|------------|--------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-------------------|------------|
| **Name**                      | ** ** | **Exercisable**                                                                            | ** ** | **Unexercisable**                                                                                                                 | ** ** | **Exercisable**          | ** ** | **Unexercisable** | ** ** | **on exercise** | ** ** | **Value Realized** | ** ** |
| Michael Szycher,  Ph.D.  |       | 3,230,743                                                                                  |       | —                                                                                                                            |       | $                        | 3,845,945  |              | $          | — |   | — |   | $ | — |   |
| Eric G. Walters               |       | 200,000                                                                                    |       | —                                                                                                                            |       | 92,000                   |       | —            |       | — |   | — |   |
| Leslie M. Taeger (2)          |       | —                                                                                     |       | —                                                                                                                            |       | —                   |       | —            |       | — |   | — |   |
|                               |            |                                                                                            |            |                                                                                                                                   |            |                          |            |                   |            |  |  |  |  |  |  |  |

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(1)             Thevalue of unexercised in-the-money options at fiscal year end assumes a fairmarket value for the Common Stock of $2.78, the closing sale price per share ofthe Common Stock as reported on the American Stock Exchange for March 31,2006.

(2)             Duringfiscal 2006, Mr. Taeger exercised 50,000 options after he ceasedemployment with the Company.

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**Item 12.**                   SecurityOwnership of Certain Beneficial Owners and Management

The following table sets forth the beneficialownership of shares of our common stock, as of March 31, 2006, of (i) eachperson known by us to beneficially own five percent (5%) or more of suchshares; (ii) each of our directors, executive officers, and significantemployees named in the Summary Compensation Table; and (iii) all of ourcurrent executive officers, directors, and significant employees as a group. Exceptas otherwise indicated, all shares are beneficially owned, and the personsnamed as owners hold investment and voting power.

Beneficialownership has been determined in accordance with Rule 13d-3 underthe Securities Exchange Act of 1934. Under this rule, certain shares may bedeemed to be beneficially owned by more than one person, if, for example,persons share the power to vote or the power to dispose of the shares. Inaddition, shares are deemed to be beneficially owned by a person if the personhas the right to acquire shares, for example, upon exercise of an option orwarrant, within sixty (60) days of March 31, 2006. In computing thepercentage ownership of any person, the amount of shares is deemed to includethe amount of shares beneficially owned by such person, and only such person,by reason of such acquisition rights. As a result, the percentage ofoutstanding shares of any person as shown in the following table does notnecessarily reflect the person’s actual voting power at any particular date.

The percentage of beneficial ownership for thefollowing table is based on 19,796,833 shares of CardioTech common stockoutstanding as of March 31, 2006. Unless otherwise indicated, the addressfor each listed stockholder is: c/o CardioTech International, Inc., 229Andover Street, Wilmington, MA 01887. To CardioTech’s knowledge, except asotherwise indicated in the footnotes to this table and pursuant to applicablecommunity property laws, the persons named in the table have sole voting andinvestment power with respect to all shares of common stock.
| **Name and address of beneficial owner** | ** ** | ** ** | ** ** | **Common stock  beneficially  owned** | ** ** | **Percentage of  outstanding  shares** | ** ** |
|-------------------------------------------------------------------|------------|------------|------------|--------------------------------------------|------------|---------------------------------------------|------------|
| Michael Szycher,  Ph.D. (1)                                       |       | 3,608,466  |       | 15.7                                       | %          |
| Michael Barretti  (2)                                             |       | 210,833    |       | 1.1                                        | %          |
| Michael Adams  (3)                                                |       | 242,589    |       | 1.2                                        | %          |
| Anthony J.  Armini, Ph.D. (4)                                     |       | 143,520    |       | 0.7                                        | %          |
| William J.  O’Neill, Jr. (5)                            |       | 80,000     |       | 0.4                                        | %          |
| Jeremiah E.  Dorsey (6)                                           |       | 61,702     |       | 0.3                                        | %          |
| Eric G. Walters  (7)                                              |       | 200,000    |       | 1.0                                        | %          |
|                                                              |       |       |       |                                       |       |
| All executive officers  and directors as a group (7 persons) (8)  |       | 4,547,110  |       | 19.0                                       | %          |

----

(1)             Includes3,230,743 shares of common stock, which may be purchased within sixty (60) daysof March 31, 2006 upon the exercise of stock options and/or warrants.

(2)             Includes194,783 shares of common stock, which may be purchased within sixty (60) daysof March 31, 2006 upon the exercise of stock options and/or warrants.

(3)             Includes242,589 shares of common stock, which may be purchased within sixty (60) daysof March 31, 2006 upon the exercise of stock options and/or warrants.

(4)             Includes137,520 shares of common stock, which may be purchased within sixty (60) daysof March 31, 2006 upon the exercise of stock options and/or warrants.

(5)             Includes80,000 shares of common stock, which may be purchased within sixty (60) days ofMarch 31, 2006 upon the exercise of stock options and/or warrants.

(6)             Includes61,702 shares of common stock, which may be purchased within sixty (60) days ofMarch 31, 2006 upon the exercise of stock options and/or warrants.

(7)             Includes200,000 shares of common stock, which may be purchased within sixty (60) daysof March 31, 2006 upon the exercise of stock options and/or warrants.

(8)             Seefootnotes (1) through (7).

39

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**Item 13.****                CertainRelationships and Related Transactions (See Financial Statements for AdditionalDisclosure)**

TheCompany has an investment in CorNova, Inc., of which Dr. Eric Ryan isPresident and a major shareholder. The Company, on July 15, 2004, enteredinto a two-year consulting agreement with Dr. Ryan, which provides for arange of payments, in either cash or common stock, for the achievement ofcertain milestones related to the manufacturing, commencement of Europeanclinical trials and the receipt of a restricted CE mark of the Company’sCardioPass synthetic coronary artery bypass graft. Total potential paymentsrange from $125,000 to $216,000 based on the timing of the milestoneachievements. As part of the agreement, Dr. Ryan has the opportunity toearn up to an additional $56,000 based on the achievement of certain milestonesrelated to other products of the Company. At As of March 31, 2006 and2005, several of the contract milestones had been achieved and, accordingly,costs totaling $38,000 and $73,000 related to performance under this contracthave been recognized as a research and development expense as for the yearsended of March 31, 2006 and 2005.

CardioTechhas entered into an employment arrangement with Mr. Scott Szycher, the sonof Dr. Michael Szycher, the Company’s Chairman, President, Chief ExecutiveOfficer and Treasurer. Mr. Scott Szycher is the worldwide sales managerfor the DermaPhylyx division and is responsible for coordinating the sales andmarketing activities of the DermaPhlyx division. Mr. Scott Szycher is paidan annual salary of $65,000 per year.

In July 1999,Dermaphylyx International, Inc., a related party, was formed by certainaffiliates of CardioTech to develop advanced wound healing products. Dermaphylyxwas merged into CardioTech International, Inc,. pursuant to which it became a whollyowned subsidiary of CardioTech. Due to CardioTech’s controlling financialinterest, Dermaphylyx has been consolidated in the financial statements ofCardioTech as of December 31, 2003. Prior to December 31, 2003, theoperations and total assets of Dermaphylyx were not material to CardioTech. SinceJuly 1999, the year Dermaphylyx was incorporated, all development expenseshave been paid by CardioTech International, Inc.

Uponthe merger, the current shareholders of Dermaphylyx received 3,827 shares of commonstock of CardioTech valued at the net book value of Dermaphylyx International, Inc.,as of December 31, 2003, which was approximately $21,000.

**Item 14.**                PrincipalAccounting Fees and Services

Thefollowing is a summary of the fees billed to the Company by the principalaccountant, Ernst & Young LLP, for professional services rendered forthe fiscal years ended March 31, 2006, 2005 and 2004. The Audit Committeeconsidered and discussed with Ernst & Young LLP the provision ofnon-audit services to the Company and the compatibility of providing suchservices with maintaining its independence as the Company’s auditor.
| **Fee Category**   | ** ** | **Years Ended March 31,** | ** ** |
|-------------------------|------------|------------------------------------------|------------|
| **(in thousands)** | ** ** | **2006**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
| Audit fees              |       | $                                        | 254        |   | $ | 227 |   | $ | 239 |   |
| Audit-related fees      |       | —                                   |       | — |   | — |   |
| Tax fees                |       | —                                   |       | — |   | — |   |
| All other fees          |       | —                                   |       | — |   | — |   |
| Total fees              |       | $                                        | 254        |   | $ | 227 |   | $ | 239 |   |

 

*Audit Fees.*Thiscategory consists of fees billed for professional services rendered for theaudit of our annual financial statements and review of financial statementsincluded in our quarterly reports and other professional services provided inconnection with regulatory filings.

40

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*Audit-Related Fees.*This category consistsof fees billed for assurance and related services that related to theperformance of the audit or review of our financial statements and are nototherwise reported under “Audit Fees”.

*Tax Fees.*This category consists of feesbilled for professional services for tax compliance, tax advice and taxplanning. These services include assistance regarding federal and state taxcompliance and acquisitions.

41

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**PART IV**

**Item 15.**                   Exhibits andFinancial Statement Schedules, and Reports on Form 10-K

(a)          Thefollowing are filed as part of this Form 10-K:

(1)          FinancialStatements: For a list of financial statements which are filed as part of this Form 10-K,See Page 33

(2)          Exhibits
| Exhibit  Number: | ** ** |                                                                                                                                                                                                                                                                                                                           | **Exhibit Title:** | ** ** |
|------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|-------------------------|------------|
| 2.1              |       | Agreement and plan of  merger and reorganization by and among Cardiotech International, Inc.,  Gish Acquisition Corp. and Gish Biomedical, Inc., incorporated by  reference to Annex A of CardioTech’s Registration Statement on Form S-4  filed on December 23, 2002.                           |
|             |       |                                                                                                                                                                                                                                                                                                                      |
| 2.2              |       | Amendment No. 1 to  Agreement and Plan of Merger and Reorganization by and among CardioTech  International, Inc., Gish Acquisition Corp. and Gish Biomedical Inc.,  incorporated by reference to Exhibit 2.2 to CardioTech’s Registration  Statement on Form S-4 filed on January 16, 2003. |
|             |       |                                                                                                                                                                                                                                                                                                                      |
| 3.1              |       | Restated Articles of  Organization of CardioTech International, Inc., filed with the Secretary  of State of Massachusetts on May 9, 1996 and incorporated herein by  reference to Exhibit 3.1 of CardioTech’s Registration Statement on  Form 10-12G/A filed on May 10, 1996.               |
|             |       |                                                                                                                                                                                                                                                                                                                      |
| 3.1.1            |       | Certificate of Vote of  Directors Establishing a Class or Series of Stock for Series A  Preferred Stock was filed as Exhibit 3.1 to CardioTech’s Form 10-Q  for the quarter ended September 30, 1998, filed on November 17,  1998, and incorporated herein by reference.          |
|             |       |                                                                                                                                                                                                                                                                                                                      |
| 3.1.2            |       | Certificate of  Correction dated May 8, 1996 and incorporated herein by reference to  Exhibit 3.1 to CardioTech’s Form 10-Q for the quarter ended  December 31, 1998, filed on February 16, 1999.                                                                                           |
|             |       |                                                                                                                                                                                                                                                                                                                      |
| 3.2              |       | Bylaws of CardioTech  International, Inc., incorporated by reference to Exhibit 3.2 of  CardioTech’s Registration Statement on Form 10 filed on May 10,  1996.                                                                                                                                   |
|             |       |                                                                                                                                                                                                                                                                                                                      |
| 4.1              |       | Form of Warrant  incorporated by reference to Exhibit 4.1 to CardioTech’s Form 8-K  filed on December 23, 2004.                                                                                                                                                                                  |
|             |       |                                                                                                                                                                                                                                                                                                                      |
| 4.2              |       | Form of Placement  Agent Warrant incorporated by reference to Exhibit 4.2 to CardioTech’s  Form 8-K filed on December 23, 2004.                                                                                                                                                                  |
|             |       |                                                                                                                                                                                                                                                                                                                      |
| 4.3              |       | Form of Additional  Investment Right incorporated by reference to Exhibit 4.3 to  CardioTech’s Form 8-K filed on December 23, 2004.                                                                                                                                                              |
|             |       |                                                                                                                                                                                                                                                                                                                      |
| 10.2             |       | Tax Matters Agreement  between PMI and CardioTech, dated May 13, 1996, was filed as  Exhibit 10.2 of the Form 10 and is incorporated herein by  reference.                                                                                                                                                 |
|             |       |                                                                                                                                                                                                                                                                                                                      |
| 10.3             |       | Amended and Restated  License Agreement between PMI and CardioTech, dated May 13, 1996, was  filed as Exhibit 10.4 of the Form 10 and is incorporated herein by  reference.                                                                                                                                |
|             |       |                                                                                                                                                                                                                                                                                                                      |
| 10.4             |       | CardioTech 1996  Employee, Director and Consultant Stock Option Plan, as amended, was filed as  Exhibit 10.4 to CardioTech’s Form 10-K for the year ended  March 31, 1998, filed on June 29, 1998, and in incorporated herein  by reference.                                                     |
|             |       |                                                                                                                                                                                                                                                                                                                      |
| 10.5             |       | Employment Agreement of  Michael Szycher, dated March 26, 1998, was filed as Exhibit 10.5 to  CardioTech’s Form 10-K for the year ended March 31, 1998,  filed on June 29, 1998, and incorporated herein by reference.                                                                      |
|             |       |                                                                                                                                                                                                                                                                                                                      |
| 10.10            |       | Development, Supply and  License Agreement between PMI and Bard Access Systems, dated  November 11, 1992, was filed as Exhibit 10.10 of the Form 10  and is incorporated herein by reference.                                                                                                              |
|             |       |                                                                                                                                                                                                                                                                                                                      |
| 10.11            |       | Lease Agreement between  CardioTech and Cummings Properties Management, Inc., dated June 26,  1998, was filed as Exhibit 10.11 to CardioTech’s Form 10-K  for the year ended March 31, 1998, filed on June 29, 1998, and in  incorporated herein by reference.                         |

 

42

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| Exhibit  Number: | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                              | **Exhibit Title:** | ** ** |
|------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|-------------------------|------------|
| 10.15            |       | Note Purchase Agreement  dated as of March 31, 1998 between CardioTech and Dresdner Kleinwort  Benson Private Equity Partners, LP (“Kleinwort Benson”) was filed as  Exhibit 99.1 to CardioTech’s Form 8-K filed with the  Securities and Exchange Commission (the “Commission”) on April 15, 1998  and is incorporated herein by reference.                                                               |
|             |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.15.1          |       | Amendment, dated as of  November 12, 1998, to Note Purchase Agreement and Registration Rights  Agreement was filed as Exhibit 10.1 to CardioTech’s Form 10-Q  for the quarter ended September 30, 1998, filed on November 16,  1998 and is incorporated herein by reference.                                                                                                                                              |
|             |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.18            |       | Form of Unit  Purchase Agreement between CardioTech and certain individuals was filed as  Exhibit 99.1 to CardioTech’s Form S-3, filed with the  Securities and Exchange Commission on February 12, 1999, and is  incorporated herein by reference.                                                                                                                                                                            |
|             |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.19            |       | Form of Warrant to  Purchase Shares of Common Stock of CardioTech issued to certain individuals  was filed as Exhibit 99.2 to CardioTech’s Form S-3, filed  with the Securities and Exchange Commission on February 12, 1999, and is  incorporated herein by reference.                                                                                                                                                        |
|             |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.20            |       | First Amendment Between  Duke Realty Limited Partnership and CDT Dated May 1, 2004 Filed as an  Exhibit to CardioTech’s Form 10-K for the year ended  March 31, 2004.                                                                                                                                                                                                                                                          |
|             |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.21            |       | Exchange and Venture  Agreement by and among CardioTech International, Inc., Implant  Sciences, Inc. and CorNova, Inc. dated March 5, 2004 filed as  an exhibit to CardioTech’s Form 10-KSB for the fiscal year ended  March 31, 2004.                                                                                                                                                                               |
|             |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.22            |       | Plan and Agreement of  Merger and Reorganization dated March 12, 2004 between CardioTech  International, Inc. and DermaPhylyx, Inc., filed as an exhibit to  CardioTech’s Form 10-KSB for the year ended March 31, 2004.                                                                                                                                                                                                  |
|             |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.23            |       | Asset Purchase  Agreement, dated as of November 19, 2004 by and among CardioTech  International, Inc., CarTika Medical, Inc., Thomas C. Carlson and  Sheila A. Carlson, incorporated by reference to Exhibit 99 to  CardioTech’s Form 8-K filed on November 22, 2004.                                                                                                                                                |
|             |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.24            |       | Securities Purchase  Agreement between Gryphon Master Fund, L.P., GSSF Master Fund, LP, Truk  Opportunity Fund, LLC, Truk International Fund, LP, Meadowbrook Opportunity  Fund LLC, Capital Ventures International, Iroquois Capital, L.P. and  CardioTech International, Inc. dated as of December 21, 2004 and  incorporated herein by reference to Exhibit 10.1 to CardioTech’s  Form 8-K filed on December 23, 2004. |
|             |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.25            |       | Registration Rights  Agreement between Gryphon Master Fund, L.P., GSSF Master Fund, LP, Truk  Opportunity Fund, LLC, Truk International Fund, LP, Meadowbrook Opportunity  Fund LLC, Capital Ventures International, Iroquois Capital, L.P. and  CardioTech International, Inc. dated as of December 21, 2004 and  incorporated herein by reference to Exhibit 10.2 to CardioTech’s  Form 8-K filed on December 23, 2004. |
|             |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.26            |       | Lock-Up Agreement  between CardioTech International, Inc. and certain of its officers and  directors dated as of December 21, 2004 and incorporated herein by  reference to Exhibit 10.3 to CardioTech’s Form 8-K filed on  December 23, 2004.                                                                                                                                                                            |
|             |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 10.27            |       | Employment Agreement of  Eric G. Walters, dated April 3, 2006, was filed as Exhibit 10.27 to  CardioTech’s Form 8-K/A, filed on April 4, 2006, and  incorporated herein by reference.                                                                                                                                                                                                                                               |
|             |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 21**             |       | Subsidiaries of  CardioTech                                                                                                                                                                                                                                                                                                                                                                                                                             |
|             |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 23.1**           |       | Consent of  Ernst & Young LLP, Independent Registered Public Accounting Firm                                                                                                                                                                                                                                                                                                                                                                   |
|             |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 31.1**           |       | Certification of Chief  Financial Officer pursuant to Section 302 Sarbanes-Oxley Act of 2002                                                                                                                                                                                                                                                                                                                                                       |
|             |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 31.2**           |       | Certification of Chief  Financial Officer pursuant to Section 302 Sarbanes-Oxley Act of 2002                                                                                                                                                                                                                                                                                                                                                       |
|             |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 32.1**           |       | Certification Pursuant  to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002                                                                                                                                                                                                                                                                                                                      |

 

43

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| Exhibit  Number | ** ** | ** **                                                                                                                         | **Exhibit Title:** | ** ** |
|-----------------|------------|------------------------------------------------------------------------------------------------------------------------------------|-------------------------|------------|
| 32.2**          |       | Certification Pursuant  to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002 |
|            |       |                                                                                                                               |
| 99.1            |       | Charter of the Compensation Committee of the Board  of Directors, effective June 6, 2006.                                     |

----

**             Filedherewith

(b)            Reportson Form 8-K: None

Copiesof these exhibits are available for a reasonable fee upon written request tothe Company at its corporate headquarters: CardioTech International, Inc.,229 Andover Street, Wilmington, MA 01887. ATTN: Thomas F. Lovett.

44

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**Report ofIndependent Registered Public Accounting Firm**

To the Board of Directorsand Stockholders of CardioTech International, Inc.:

Wehave audited the accompanying consolidated balance sheets of CardioTechInternational, Inc. as of March 31, 2006 and 2005, and the relatedconsolidated statements of operations, stockholders’ equity, and cash flows foreach of the three years in the period ended March 31, 2006. Thesefinancial statements are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these financial statements based onour audits.

Weconducted our audits in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that weplan and perform the audit to obtain reasonable assurance about whether thefinancial statements are free of material misstatement. We were not engaged toperform an audit of the Company’s internal control over financial reporting. Ouraudits included consideration of internal control over financial reporting as abasis for designing audit procedures that are appropriate in the circumstances,but not for the purpose of expressing an opinion on the effectiveness of theCompany’s internal control over financial reporting. Accordingly, we express no such opinion. An auditalso includes examining, on a test basis, evidence supporting the amounts anddisclosures in the financial statements, assessing the accounting principlesused and significant estimates made by management, and evaluating the overallfinancial statement presentation. We believe that our audits provide areasonable basis for our opinion.

In our opinion, the financial statements referred toabove present fairly, in all material respects, the consolidated financial positionof CardioTech International, Inc. at March 31, 2006 and 2005 and theconsolidated results of their operations and their cash flows for each of thethree years in the period ended March 31, 2006, in conformity with U.S.generally accepted accounting principles.
|  |   | /s/ Ernst & Young LLP |
|--|--------|--------------------------------|

 

Boston, MassachusettsJune 16, 2006

F-1

----

**CardioTechInternational, Inc.Consolidated Balance Sheets***(Inthousands, except share and per share amounts)*
| ** **                                                                                                                                                             | ** ** | **March 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|
| ** **                                                                                                                                                             | ** ** | **2006**           | ** ** | **2005** | ** ** |
| **ASSETS**                                                                                                                                                             | ** ** | ** **         | ** ** | ** ** | ** ** |
|                                                                                                                                                                   |       |               |       |   |   |
| Current assets:                                                                                                                                                        |       |               |       |   |   |
| Cash and cash equivalents                                                                                                                                              |       | $                  | 6,841      |   | $ | 7,469 |   |
| Accounts receivable-trade, net of allowance of $572  and $326 as of March 31, 2006 and 2005, respectively                                                    |       | 2,851              |       | 3,399 |   |
| Accounts receivable-other                                                                                                                                              |       | 265                |       | 231 |   |
| Inventories                                                                                                                                                            |       | 4,786              |       | 4,802 |   |
| Prepaid expenses and other current assets                                                                                                                              |       | 210                |       | 195 |   |
| Total current assets                                                                                                                                                   |       | 14,953             |       | 16,096 |   |
| Property, plant  and equipment, net                                                                                                                                    |       | 4,059              |       | 4,549 |   |
| Amortizable  intangible assets, net                                                                                                                                    |       | 584                |       | 776 |   |
| Goodwill                                                                                                                                                               |       | 487                |       | 1,638 |   |
| Other assets                                                                                                                                                           |       | 130                |       | 198 |   |
| Investment in  CorNova, Inc.                                                                                                                                      |       | 238                |       | 505 |   |
| Total assets                                                                                                                                                           |       | $                  | 20,451     |   | $ | 23,762 |   |
|                                                                                                                                                                   |       |               |       |   |   |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                                                                                                                         | ** ** | ** **         | ** ** | ** ** | ** ** |
| Current liabilities:                                                                                                                                                   |       |               |       |   |   |
| Accounts payable                                                                                                                                                       |       | $                  | 1,750      |   | $ | 1,664 |   |
| Accrued expenses                                                                                                                                                       |       | 936                |       | 652 |   |
| Deferred revenue                                                                                                                                                       |       | 132                |       | 263 |   |
| Total current liabilities                                                                                                                                              |       | 2,818              |       | 2,579 |   |
| Deferred rent                                                                                                                                                          |       | 129                |       | 173 |   |
| Commitments and  contingencies (Note G)                                                                                                                                |       | —             |       | — |   |
| Stockholders’ equity:                                                                                                                                             |       |               |       |   |   |
| Preferred stock; $.01 par value; 5,000,000 shares  authorized; 500,000 shares issued and none outstanding as of March 31,  2006 and 2005, respectively            |       | —             |       | — |   |
| Common stock; $.01 par value; 50,000,000 shares  authorized; 19,796,833 and 19,258,989 shares issued and outstanding as of  March 31, 2006 and 2005, respectively |       | 198                |       | 192 |   |
| Additional paid-in capital                                                                                                                                             |       | 36,685             |       | 35,263 |   |
| Accumulated deficit                                                                                                                                                    |       | (19,339            | )          | (14,270 | ) |
| Accumulated other comprehensive loss                                                                                                                                   |       | (40                | )          | (175 | ) |
| Total stockholders’ equity                                                                                                                                        |       | 17,504             |       | 21,010 |   |
| Total  liabilities and stockholders’ equity                                                                                                                       |       | $                  | 20,451     |   | $ | 23,762 |   |

 

The accompanyingnotes are an integral part of these financial statements.

F-2

----

**CardioTechInternational, Inc.Consolidated Statements of Operations***(In thousands, except per share amounts)*
| ** **                                                             | ** ** | **For The Years Ended March 31,** | ** ** |
|------------------------------------------------------------------------|------------|------------------------------------------------------------|------------|
| ** **                                                             | ** ** | **2006**                                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenues:                                                              |       |                                                       |       |   |   |   |   |
| Product sales                                                          |       | $                                                          | 21,404     |   | $ | 21,067 |   | $ | 21,323 |   |
| Royalties                                                              |       | 977                                                        |       | 774 |   | 476 |   |
|                                                                   |       | 22,381                                                     |       | 21,841 |   | 21,799 |   |
| Cost of sales                                                          |       | 18,304                                                     |       | 15,645 |   | 15,670 |   |
| Gross margin                                                           |       | 4,077                                                      |       | 6,196 |   | 6,129 |   |
|                                                                   |       |                                                       |       |   |   |   |   |
| Operating expenses:                                                    |       |                                                       |       |   |   |   |   |
| Research and development, regulatory and engineering                   |       | 1,385                                                      |       | 1,258 |   | 1,065 |   |
| Selling, general and administrative                                    |       | 6,162                                                      |       | 6,015 |   | 5,655 |   |
| Impairment of goodwill                                                 |       | 1,152                                                      |       | — |   | — |   |
| Non-cash compensation & research contract  expense (1)        |       | 193                                                        |       | 78 |   | 1,171 |   |
| Severance payment                                                      |       | —                                                     |       | — |   | 372 |   |
| CarTika acquisition expenses                                           |       | —                                                     |       | 333 |   | — |   |
|                                                                   |       | 8,892                                                      |       | 7,684 |   | 8,263 |   |
| Loss from  operations                                                  |       | (4,815                                                     | )          | (1,488 | ) | (2,134 | ) |
| Interest and other  income and expense:                                |       |                                                       |       |   |   |   |   |
| Interest expense                                                       |       | —                                                     |       | (20 | ) | (70 | ) |
| Interest income                                                        |       | 42                                                         |       | 38 |   | 45 |   |
| Other income (expense)                                                 |       | 104                                                        |       | (12 | ) | 645 |   |
| Other income, net                                                      |       | 146                                                        |       | 6 |   | 620 |   |
| Equity in net  loss of CorNova, Inc.                              |       | (400                                                       | )          | (113 | ) | (1 | ) |
| Net loss                                                               |       | $                                                          | (5,069     | ) | $ | (1,595 | ) | $ | (1,515 | ) |
| Net loss per  common share, basic and diluted                          |       | $                                                          | (0.26      | ) | $ | (0.09 | ) | $ | (0.10 | ) |
| Shares used in  computing net loss per common share, basic and diluted |       | 19,451                                                     |       | 18,023 |   | 15,421 |   |

----

(1)             Forthe years ended March 31, 2006 and 2005, non-cash compensation expense wasrelated to general and administrative expenses. For the year ended March 31,2004, non-cash compensation and research contract expense included $210,000 ofresearch contract costs and $961,000 of general and administrative expenses.

The accompanyingnotes are an integral part of these financial statements.

F-3

----

**CardioTech International,Inc.Consolidated Statements of Stockholders’ EquityFor the Years Ended March 31, 2004, 2005 and 2006**
| ** **                                                                              | ** ** | **Common Stock**            | ** ** | **Additional** | ** ** | ** **           | ** ** | **Other**                | ** ** | **Subscription**          | ** ** | ** **                                     | ** ** | **Total**           | ** ** |
|-----------------------------------------------------------------------------------------|------------|----------------------------------|------------|----------------|------------|----------------------|------------|--------------------------|------------|---------------------------|------------|------------------------------------------------|------------|---------------------|------------|
| ***(in thousands)***                                                               | ** ** | **Number of   Shares** | ** ** | **Amount**     | ** ** | **Paid-in  Capital** | ** ** | **Accumulated  Deficit** | ** ** | **Comprehensive  Income** | ** ** | **Receivable from  Related Parties** | ** ** | **Treasury  Stock** | ** ** | **Stockholders’  Equity (Deficit)** | ** ** |
| Balance as of  April 1, 2003                                                       |       | 9,228                            |       | $              | 92         |                 | $          | 16,168                   |       | $                         | (11,160    | )                                              | $          | —              |       | $ | (178 | ) | $ | (165 | ) | $ | 4,757 |   |
| Issuance of  common stock in connection with exercise of stock options                  |       | 2,354                            |       | 24             |       | 4,960                |       | —                   |       | —                    |       | —                                         |       | —              |       | 4,984 |   |
| Issuance of  common stock in connection with exercise of warrants                       |       | 1,159                            |       | 12             |       | 1,758                |       | —                   |       | —                    |       | —                                         |       | —              |       | 1,770 |   |
| Fair value of  options granted to consultants                                           |       | —                           |       | —         |       | 92                   |       | —                   |       | —                    |       | —                                         |       | —              |       | 92 |   |
| Fair value due  to modification of warrant terms                                        |       | —                           |       | —         |       | 344                  |       | —                   |       | —                    |       | —                                         |       | —              |       | 344 |   |
| Issuance of  shares related to the Gish merger                                          |       | 4,902                            |       | 49             |       | 8,162                |       | —                   |       | —                    |       | —                                         |       | —              |       | 8,211 |   |
| Issuance of  shares related to the Dermaphylyx merger                                   |       | 4                                |       | —         |       | 21                   |       | —                   |       | —                    |       | —                                         |       | —              |       | 21 |   |
| Investment in CorNova, Inc.                                                        |       | 13                               |       | —         |       | 75                   |       | —                   |       | —                    |       | —                                         |       | —              |       | 75 |   |
| Issuance of  common stock to Implant Sciences Corporation per contract terms            |       | 40                               |       | —         |       | 249                  |       | —                   |       | —                    |       | —                                         |       | —              |       | 249 |   |
| Interest due on  officers’ notes                                                   |       | —                           |       | —         |       | —               |       | —                   |       | —                    |       | (9                                             | )          | —              |       | (9 | ) |
| Payment of  interest due on officers’ notes                                        |       | —                           |       | —         |       | —               |       | —                   |       | —                    |       | 37                                             |       | —              |       | 37 |   |
| Note receivable  from related party                                                     |       | —                           |       | —         |       | —               |       | —                   |       | —                    |       | (166                                           | )          | —              |       | (166 | ) |
| Payment of note  receivable from related party                                          |       | —                           |       | —         |       | —               |       | —                   |       | —                    |       | 26                                             |       | —              |       | 26 |   |
| Payment of  subscription receivable                                                     |       | —                           |       | —         |       | —               |       | —                   |       | —                    |       | 290                                            |       | —              |       | 290 |   |
| Issuance of treasury  shares, at cost                                                   |       | —                           |       | —         |       | 212                  |       | —                   |       | —                    |       | —                                         |       | 163                 |       | 375 |   |
| Purchase of  stock, at cost                                                             |       | —                           |       | —         |       | —               |       | —                   |       | —                    |       | —                                         |       | (180                | )          | (180 | ) |
| Comprehensive  income from CorNova, Inc.                                           |       | —                           |       | —         |       | —               |       | —                   |       | 7                         |       | —                                         |       | —              |       | 7 |   |
| Net loss                                                                                |       | —                           |       | —         |       | —               |       | (1,515                   | )          | —                    |       | —                                         |       | —              |       | (1,515 | ) |
| Balance at  March 31, 2004                                                         |       | 17,700                           |       | 177            |       | 32,041               |       | (12,675                  | )          | 7                         |       | —                                         |       | (182                | )          | 19,368 |   |
| Issuance of  common stock in connection with exercise of stock options                  |       | 179                              |       | 2              |       | 252                  |       | —                   |       | —                    |       | —                                         |       | —              |       | 254 |   |
| Fair value of  options granted to consultants                                           |       | —                           |       | —         |       | 58                   |       | —                   |       | —                    |       | —                                         |       | —              |       | 58 |   |
| Issuance of  common stock in connection with private placement, net of $314 of expenses |       | 1,140                            |       | 11             |       | 2,410                |       | —                   |       | —                    |       | —                                         |       | —              |       | 2,421 |   |
| Investment in  CorNova, Inc.                                                       |       | 309                              |       | 3              |       | 747                  |       | —                   |       | —                    |       | —                                         |       | —              |       | 750 |   |
| Compensation  expense related to acceleration of employee stock options                 |       | —                           |       | —         |       | 20                   |       | —                   |       | —                    |       | —                                         |       | —              |       | 20 |   |
| Purchase of  stock, at cost                                                             |       | —                           |       | —         |       | —               |       | —                   |       | —                    |       | —                                         |       | (84                 | )          | (84 | ) |
| Reclass of  repurchased stock as unissued according to Mass. Business Corporation Act   |       | (69                              | )          | (1             | )          | (265                 | )          | —                   |       | —                    |       | —                                         |       | 266                 |       | — |   |
| Comprehensive  loss from CorNova, Inc.                                             |       | —                           |       | —         |       | —               |       | —                   |       | (182                      | )          | —                                         |       | —              |       | (182 | ) |
| Net loss                                                                                |       | —                           |       | —         |       | —               |       | (1,595                   | )          | —                    |       | —                                         |       | —              |       | (1,595 | ) |
| Balance at  March 31, 2005                                                         |       | 19,259                           |       | $              | 192        |                 | $          | 35,263                   |       | $                         | (14,270    | )                                              | $          | (175                | )          | $ | — |   | $ | — |   | $ | 21,010 |   |
|                                                                                    |       |                             |       |           |       |                 |       |                     |       |                      |       |                                           |       |                |       |   |   |

 

The accompanying notes are an integral part of these financialstatements.

F-4

 

----

**CardioTechInternational, Inc.Consolidated Statements of Stockholders’ EquityFor the Years Ended March 31, 2004, 2005 and 2006**
| ** **                                                              | ** ** | **Common Stock**      | ** ** | **Additional** | ** ** | ** **                 | ** ** | **Other**                | ** ** | **Subscription**          | ** ** | ** **                                     | ** ** | **Total**           | ** ** |
|-------------------------------------------------------------------------|------------|----------------------------|------------|----------------|------------|----------------------------|------------|--------------------------|------------|---------------------------|------------|------------------------------------------------|------------|---------------------|------------|
| ***(in thousands)***                                                    | ** ** | **Number of  Shares** | ** ** | **Amount**     | ** ** | **Paid-in   Capital** | ** ** | **Accumulated  Deficit** | ** ** | **Comprehensive  Income** | ** ** | **Receivable from  Related Parties** | ** ** | **Treasury  Stock** | ** ** | **Stockholders’  Equity (Deficit)** | ** ** |
| Balance at  March 31, 2005                                         |       | 19,259                     |       | $              | 192        |                       | $          | 35,263                   |       | $                         | (14,270    | )                                              | $          | (175                | )          | $ | — |   | $ | — |   | $ | 21,010 |   |
| Issuance of  common stock in connection with exercise of stock options  |       | 543                        |       | 6              |       | 1,240                      |       | —                   |       | —                    |       | —                                         |       | —              |       | 1,246 |   |
| Fair value of  options granted to consultant                            |       | —                     |       | —         |       | 193                        |       | —                   |       | —                    |       | —                                         |       | —              |       | 193 |   |
| Compensation  expense related to acceleration of employee stock options |       | —                     |       | —         |       | 1                          |       | —                   |       | —                    |       | —                                         |       | —              |       | 1 |   |
| Repurchase of  common stock, at cost                                    |       | (5                         | )          | —         |       | (12                        | )          | —                   |       | —                    |       | —                                         |       | —              |       | (12 | ) |
| Comprehensive  income from CorNova, Inc.                           |       | —                     |       | —         |       | —                     |       | —                   |       | 135                       |       | —                                         |       | —              |       | 135 |   |
| Net loss                                                                |       | —                     |       | —         |       | —                     |       | (5,069                   | )          | —                    |       | —                                         |       | —              |       | (5,069 | ) |
| Balance at  March 31, 2006                                         |       | 19,797                     |       | $              | 198        |                       | $          | 36,685                   |       | $                         | (19,339    | )                                              | $          | (40                 | )          | $ | — |   | $ | — |   | $ | 17,504 |   |

 

The accompanying notes are an integral part of these financialstatements.

F-5

 

----

 

**CardioTech International, Inc.Consolidated Statements of Cash Flows***(In thousands)*

 
| ** **                                                            | ** ** | **For The Years Ended March 31,** | ** ** |
|-----------------------------------------------------------------------|------------|------------------------------------------------------------|------------|
| ** **                                                            | ** ** | **2006**                                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Cash flows from  operating activities:                                |       |                                                       |       |   |   |   |   |
| Net loss                                                              |       | $                                                          | (5,069     | ) | $ | (1,595 | ) | $ | (1,515 | ) |
| Adjustments to  reconcile net loss to net cash flows:                 |       |                                                       |       |   |   |   |   |
| Impairment of goodwill                                                |       | 1,152                                                      |       | — |   | — |   |
| Depreciation and amortization                                         |       | 930                                                        |       | 1,016 |   | 1,092 |   |
| Equity in net loss of CorNova, Inc.                              |       | 400                                                        |       | 113 |   | 1 |   |
| Provision for doubtful accounts                                       |       | 245                                                        |       | 202 |   | 24 |   |
| Provision for excess and obsolete inventory                           |       | 642                                                        |       | 115 |   | 48 |   |
| Fair value ascribed to options granted to consultant                  |       | 193                                                        |       | — |   | 232 |   |
| Compensation expense related to treasury shares  issued               |       | —                                                     |       | — |   | 293 |   |
| Fair value ascribed to options granted to  nonemployees               |       | 1                                                          |       | 58 |   | 92 |   |
| Deferred rent                                                         |       | (44                                                        | )          | (47 | ) | (42 | ) |
| Compensation expense related to modification of  warrants and options |       | —                                                     |       | 20 |   | 344 |   |
| Non-cash research contract expense                                    |       | —                                                     |       | — |   | 210 |   |
| Decrease in carrying value of CorNova, Inc.                      |       | —                                                     |       | — |   | 32 |   |
| Changes in  assets and liabilities:                                   |       |                                                       |       |   |   |   |   |
| Accounts receivable-trade                                             |       | 302                                                        |       | (321 | ) | (141 | ) |
| Accounts receivable-other                                             |       | (34                                                        | )          | (29 | ) | (71 | ) |
| Inventories                                                           |       | (626                                                       | )          | (350 | ) | (446 | ) |
| Prepaid expenses and other current assets                             |       | (15                                                        | )          | (22 | ) | 155 |   |
| Accounts payable                                                      |       | 86                                                         |       | 340 |   | 371 |   |
| Accrued expenses                                                      |       | 285                                                        |       | (94 | ) | (139 | ) |
| Deferred revenue                                                      |       | (131                                                       | )          | 107 |   | (109 | ) |
| Net cash flows (used in) provided by operating  activities            |       | (1,683                                                     | )          | (487 | ) | 431 |   |
| Cash flows from  investing activities:                                |       |                                                       |       |   |   |   |   |
| Purchase of property, plant and equipment                             |       | (248                                                       | )          | (712 | ) | (2,447 | ) |
| Decrease in other assets                                              |       | 69                                                         |       | 22 |   | 484 |   |
| Payment of acquisition costs, net of cash acquired                    |       | —                                                     |       | (333 | ) | (498 | ) |
| Net cash flows used in investing activities                           |       | (179                                                       | )          | (1,023 | ) | (2,461 | ) |
| Cash flows from  financing activities:                                |       |                                                       |       |   |   |   |   |
| Net repayments on revolving credit line                               |       | —                                                     |       | (730 | ) | (474 | ) |
| Net proceeds from issuance of common stock                            |       | 1,246                                                      |       | 2,676 |   | 6,503 |   |
| Repayment of note receivables from officers and  directors            |       | —                                                     |       | — |   | 290 |   |
| Purchase of treasury stock                                            |       | (12                                                        | )          | (84 | ) | (111 | ) |
| Net cash flows provided by financing activities                       |       | 1,234                                                      |       | 1,862 |   | 6,208 |   |
| Net change in cash and cash equivalents                               |       | (628                                                       | )          | 352 |   | 4,178 |   |
| Cash and cash equivalents at beginning of period                      |       | 7,469                                                      |       | 7,117 |   | 2,939 |   |
| Cash and cash equivalents at end of period                            |       | $                                                          | 6,841      |   | $ | 7,469 |   | $ | 7,117 |   |
| Supplemental Disclosure  of Cash Flow Information:                    |       |                                                       |       |   |   |   |   |
| Interest  received                                                    |       | $                                                          | 23         |   | $ | 38 |   | $ | 45 |   |
| Interest paid                                                         |       | $                                                          | 4          |   | $ | 20 |   | $ | 70 |   |
| Taxes paid                                                            |       | $                                                          | 6          |   | $ | 12 |   | $ | 7 |   |

 

**The accompanying notes are anintegral part of these financial statements.**

F-6

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** **

**CARDIOTECH INTERNATIONAL, INC.**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**Nature of Business**

***CardioTech International, Inc. (including itswholly-owned subsidiaries, collectively “CardioTech” or the “Company”) is amedical device company that develops, manufactures and sells advanced productsfor the treatment of cardiovascular and other diseases. Many of the productssold and under development address overall annual worldwide markets exceeding $1 billion. The Company’ssubsidiaries and divisions are Gish Biomedical, Inc. (“Gish” orcardiopulmonary products division), Catheter and Disposables Technology, Inc.(“CDT” or private label medical device manufacturing), and CT Biomaterials (“Biomaterials”)The Company operates in one segment, medical device manufacturing and sales.***

***The Company is using its proprietary technology to developand manufacture the CardioPass***TM synthetic coronary artery bypass grafts (“SynCAB”),made of ChronoFlexTM. If successfully developed, the Company believes that the CardioPassgraft may be used initially to provide an alternative to patients withinsufficient or inadequate native vessels for use in coronary artery bypassgraft (“CABG”) surgery as a result of repeat procedures, trauma, disease orother factors. Gish manufactures single use cardiopulmonary bypass productsthat have a disposable component. CDT is an original equipment manufacturer andsupplier of private-label advanced disposable medical devices from concept tofinished packaged and sterilized products. Dermaphylyx markets and sellsproprietary moist wound dressings available for low exudating and bleedingwounds. The biomaterials division develops, manufactures and sells ChronoFlex,a family of polyurethanes that have been demonstrated to be biocompatible andnon-toxic.

***CardioTech has partnered to develop a drug-eluting stent. TheCompany has a 30% ownership interest in the common stock of CorNova, Inc.(“CorNova”), a privately-held, development stage company focused on thedevelopment of a next-generation drug-eluting stent. The Company has a 19%interest in the outstanding common and preferred stock of CorNova (See Note P).***

***The Company’s corporate headquarters are located inWilmington, Massachusetts, with manufacturing operations in Massachusetts,California and Minnesota.***

**A.**            Summary of Significant Accounting Policies:

***Accounting Principles***

***The consolidated financial statements and accompanying notesare prepared in accordance with accounting principles generally accepted in theUnited States of America.***

***Basis of Consolidation***

***The consolidated financial statements include the accountsof the Company and its wholly-owned subsidiaries. All significant intercompanybalances and transactions have been eliminated. The Company’s investment inCorNova is accounted for using the equity method of accounting in accordancewith APB Opinion No. 18, “The Equity Method of Accounting for Investmentsin Common Stock.”***

***Use of Accounting Estimates***

***The preparation of consolidated financial statements inconformity with accounting principles generally accepted in the United Statesof America requires management to make certain estimates and assumptions thataffect the reported amounts of assets and liabilities and disclosure ofcontingent assets and liabilities at the date of the consolidated financialstatements and the reported amounts of revenue and expenses during the reportedperiod. Actual results could differ from those estimates.***

*Uncertainties*

TheCompany is subject to risks common to companies in the medical device industry,including, but not limited to, development of new technology innovations bycompetitors of the Company, dependence on key personnel, protection ofproprietary technology, and compliance with FDA government regulations.

*Cash and Cash Equivalents*

Cashand cash equivalents include cash on hand, demand deposits and short-terminvestments with maturities of three months or less when acquired. Cashequivalents represent a deposit in a money market account.

F-7

----

 

**CARDIOTECH INTERNATIONAL, INC.**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

*RevenueRecognition—Product, Research and Royalty Revenue*

TheCompany recognizes revenue in accordance with Staff Accounting Bulletin (“SAB”)No. 104, “Revenue Recognition in Financial Statements.”  The Company recognizes revenue from productsales upon shipment, provided that a purchase order has been received or acontract has been executed, there are no uncertainties regarding customeracceptance, the sales price is fixed or determinable and collection is deemedprobable. If uncertainties regarding customer acceptance exist, the Companyrecognizes revenue when those uncertainties are resolved and title has beentransferred to the customer. Amounts collected or billed prior to satisfyingthe above revenue recognition criteria are recorded as deferred revenue. TheCompany also receives license and royalty fees for the use of its proprietarybiomaterials. CardioTech recognizes these fees as revenue in accordance withthe terms of the contracts. Contracted product design and development projects  are recognized on a time and materials basisas services are performed.

Generally,the customer specifies the delivery method and is responsible for deliverycosts. However, in certain situations, the customer specifies the deliverymethod and requests the Company pay the delivery costs and then invoice thedelivery costs to the customer or include an estimate of the delivery costs inthe price of the product. Delivery costs billed to customers by the Company forthe years ended March 31, 2006, 2005 and 2004 of $409,000, $409,000 and$481,000, respectively, have been recorded as revenue.

*Research and Development,Regulatory and Engineering Expense*

Researchand development, regulatory and engineering expenditures for the years ended March 31,2006, 2005 and 2004 were $1,385,000, $1,258,000 and $1,065,000, respectively,and consisted primarily of salaries and related costs and are expensed asincurred. The Company has six full time employees that work on a variety ofprojects, including production support. In addition, the Company allocates aportion of Dr. Szycher’s salary and related costs to this income statementcategory.

*Reporting ComprehensiveIncome (Loss)*

SFASNo. 130, “Reporting Comprehensive Income (Loss),” establishes standardsfor the reporting and display of comprehensive income and its components in theconsolidated financial statements. Comprehensive income (loss) is the total ofnet income (loss) and all other non owner changes in equity including suchitems as unrealized holding gains (losses) on securities classified asavailable-for-sale, foreign currency translation adjustments and minimumpension liability adjustments. During the years ended March 31, 2006, 2005and 2004, the Company’s only item of other comprehensive income (loss) was itsequity in unrealized holding gains (losses) on securities classified asavailable for sale, recorded by CorNova, Inc. of ($135,000), ($182,000)and $7,000, respectively.

*Basic and DilutedEarnings Per Share*

TheCompany follows SFAS No. 128, “Earnings Per Share,” where basic earningsper share is computed by dividing net income (loss) by the weighted averagenumber of common shares outstanding during the period. Diluted earnings pershare are based upon the weighted average number of common shares outstanding duringthe period plus additional weighted average common equivalent sharesoutstanding during the period. Common equivalent shares result from the assumedexercise of outstanding stock options and warrants, the proceeds of which arethen assumed to have been used to repurchase outstanding common stock using thetreasury stock method. In addition, the numerator is adjusted for any changesin income or loss that would result from the assumed conversion of potentialshares. At March 31, 2006, 2005 and 2004, potentially dilutive shares of7,091,611, 8,584,311 and 4,048,773, respectively, were excluded from theearnings per share calculation because their effect would be antidilutive. Sharesdeemed to be antidilutive include stock options, warrants and additionalinvestment rights.

*Property and Equipment*

Propertyand equipment are stated at cost. Equipment is depreciated using thestraight-line method over the estimated useful lives of the assets, rangingfrom three to seven years, leasehold improvements are amortized using thestraight-line method over the shorter of the estimated life of the asset or theremaining term of the lease, and the Company’s building is depreciated usingthe straight-line method over 40 years. Expenditures for repairs and 

F-8

----

 

**CARDIOTECH INTERNATIONAL, INC.**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

maintenance are charged to expense as incurred. TheCompany records construction in process in the appropriate asset category andcommences depreciation upon completion and commencement of use of the asset.

*Inventory*

Inventories are stated at the lower of cost (first-in,first-out) or net realizable value and consists of the following:
| ** **                | ** ** | **March 31,** | ** ** |
|---------------------------|------------|--------------------|------------|
| ***(in thousands)*** | ** ** | **2006**           | ** ** | **2005** | ** ** |
| Raw materials             |       | $                  | 2,143      |   | $ | 2,343 |   |
| Work in progress          |       | 1,033              |       | 1,182 |   |
| Finished goods            |       | 1,610              |       | 1,277 |   |
| Total inventories         |       | $                  | 4,786      |   | $ | 4,802 |   |

 

The Company recorded a charge of $556,000 forimpairment of custom inventory held by the Company at March 31, 2006related to production of a key customer’s products.

*Income Taxes*

TheCompany follows SFAS No. 109, “Accounting for Income Taxes,” wheredeferred tax assets and liabilities are recognized based on temporarydifferences between the financial statements and tax basis of assets andliabilities using currently enacted tax rates. A valuation reserve against thenet deferred assets is recorded, if, based upon the weight of availableevidence, it is more likely than not that some or all of the deferred taxassets will not be realized.

*Intangible Assets andImpairment of Long-Lived Assets*

TheCompany evaluates its long-lived assets, which include property and equipmentand finite-lived intangible assets for impairment as events and circumstancesindicate that the carrying amount may not be recoverable and at a minimum ateach balance sheet date. The Company evaluates the reliability of itslong-lived assets based on profitability and undiscounted cash flowexpectations for the related asset or subsidiary. Property and equipment andamortizable intangibles are subject to SFAS No. 144, “Accounting for theImpairment or Disposal of Long-Lived Assets.” Non-amortizable intangibles, such as goodwill, are subject to SFAS No. 142,“Goodwill and Other Intangible Assets.”

Our long-lived assets include intangible assets andgoodwill. In assessing the recoverability of our intangible assets andgoodwill, we must make assumptions in determining the fair value of the assetby estimating future cash flows and considering other factors, including oursignificant changes in the manner or use of the assets, or negative industryreports or economic conditions. If those estimates or their related assumptionschange in the future, we may be required to record additional impairmentcharges for those assets. Under the provisions of Statement of Financial AccountingStandards, or SFAS No. 142, “Goodwill and Other Intangible Assets,” we arerequired to test our goodwill and other intangible assets for impairment on anannual basis, or more frequently if indicators of impairment exist. Ourreporting units consist of our three operating divisions and goodwill isallocated to the divisions for impairment assessment. During the quarter ended March 31,2006 the Company tested its intangible assets for impairment and based on theresults of the first step of the goodwill impairment test, the Company hasdetermined that the fair value of goodwill of its cardiopulmonary andprivate-label medical device manufacturing division were less than therespective carrying amounts and, therefore, goodwill impairment existed as of March 31,2006. As a result, the second step of the goodwill impairment test wascompleted and the Company recorded a charge of $598,000 for the impairment ofgoodwill related to our private-label medical device manufacturing division primarilydue to the current cessation of a major customer. In addition, there was acharge of $554,000 for the impairment of goodwill for its cardiopulmonaryproducts division due to continued reduced demand for these products. TheCompany will be required to continue to perform a goodwill impairment test onan annual basis and the next test is scheduled during the quarter ending March 31,2007.

Asof March 31, 2006, CardioTech had unamortized goodwill of $487,000 and amortizableidentifiable intangible assets of $584,000. Amortization expense related toidentifiable intangible assets that will continue to be amortized in the futureis approximately $192,000 for the fiscal year ended March 31, 2006.

F-9

----

 

**CARDIOTECH INTERNATIONAL, INC.**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

The estimated amortization expense related to otheridentifiable intangible assets for the next five years is as follows:
| **Fiscal Years Ended March 31,*(in thousands)*** | ** ** | ** ** | ** ** |
|---------------------------------------------------------------------------|------------|------------|------------|
| 2007                                                                      |       | $          | 118        |   |
| 2008                                                                      |       | 110        |       |
| 2009                                                                      |       | 110        |       |
| 2010                                                                      |       | 110        |       |
| 2011                                                                      |       | 18         |       |
|                                                                      |       | $          | 466        |   |

 

*Stock Based Compensation*

TheCompany accounts for stock options granted to employees under the intrinsicvalue method in accordance with APB Opinion No. 25, *Accounting for Stock Issued to Employees*,and related interpretations rather than the alternative fair value accountingprovided for under Statement of Financial Standards No. 123, *Accounting for Stock-Based Compensation (“SFAS123”)*, which requires the use of option valuation models that werenot developed for use in valuing employee stock options. The Company also hasissued options to non-employees for services provided to the Company. Suchoptions have been accounted for at fair value in accordance with the provisionsof SFAS 123 and the Emerging Issues Task Force consensus in Issue No. 96-18,*Accounting for Equity Instruments That areIssued to Other Than Employees for Acquiring, or in Conjunction With SellingGoods or Services*. Such compensation expense is recognized based onthe vested portion of the compensation cost at the respective balance sheetdates.

Had compensationcost for the Company’s stock option grants been determined consistent with SFAS123, the Company’s net loss and net loss per share would approximate the proforma amounts below:
| ** **                                                                                                                                       | ** ** | **Years Ended March 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| **(*in thousands, except per share data)***                                                                             | ** ** | **2006**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net loss, as  reported                                                                                                                           |       | $                                        | (5,069     | ) | $ | (1,595 | ) | $ | (1,515 | ) |
| Add: Stock-based employee compensation expense  included in reported net loss, net of related tax effects                                        |       | 1                                        |       | 20 |   | — |   |
| Deduct: Stock-based employee compensation expense  determined under fair value based method for all employee awards, net of  related tax effects |       | (978                                     | )          | (7,418 | ) | (2,790 | ) |
| Pro forma, net  loss                                                                                                                             |       | $                                        | (6,046     | ) | $ | (8,993 | ) | $ | (4,305 | ) |
|                                                                                                                                             |       |                                     |       |   |   |   |   |
| Basic and diluted loss  per share:                                                                                                               |       |                                     |       |   |   |   |   |
| As reported                                                                                                                                      |       | $                                        | (0.26      | ) | $ | (0.09 | ) | $ | (0.10 | ) |
| Pro forma                                                                                                                                        |       | $                                        | (0.31      | ) | $ | (0.50 | ) | $ | (0.28 | ) |

 

The significantdifference between “As reported” and “Pro forma” results for the year ended March 31,2005 relates primarily to the effect of the acceleration of the vesting ofstock options on July 8, 2004,  andthe granting in fiscal 2005 of 2,073,500 fully vested stock options.

On July 8,2004, the Board of Directors of the Company accelerated the vesting of alloutstanding options, such that at July 8, 2004, all outstanding optionsare fully vested. The Company accelerated the vesting of the options to avoidcompensation expense associated with the adoption of SFAS 123R. This actionresulted in the immediate vesting of options to purchase 922,503 shares of the Company’s common stock. Nocompensation cost was recognized because of the acceleration, however, shouldan optionee realize a benefit from the acceleration that they would not haveotherwise been eligible for, then the Company would recognize compensationexpense. The compensation expense would be determined by the difference betweenthe closing stock price at July 8, 2004 of $3.92 and the option exerciseprice, multiplied by the 

F-10

----

 

**CARDIOTECH INTERNATIONAL, INC.**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

number of shares on which the optionee obtained abenefit from the accelerated vesting. At July 8, 2004 the total potentialcompensation expense was $149,000. Compensation cost due to the acceleration of$1,000 and $20,000 has been recorded for fiscal years 2006 and 2005, respectively. At March 31, 2006, thetotal remaining potential unrecognized compensation cost from the accelerationis $2,000.

TheBlack-Scholes option valuation model was developed for use in estimating thefair value of traded options, which have no vesting restrictions and are fullytransferable. In addition, option valuation models require the input of highlysubjective assumptions including the expected stock price volatility. Becausethe Company’s employee stock options have characteristics significantlydifferent from those of traded options, and because changes in the subjectiveinput assumptions can materially affect the fair value estimate, in management’sopinion, the existing models do not necessarily provide a reliable singlemeasure of the fair value of its employee stock options.

The fair value of each option granted during thefiscal years 2006, 2005 and 2004 is estimated on the date of grant using theBlack-Scholes option pricing model with the following weighted averageassumptions:
| ** **                     | ** ** | **Years Ended March 31,** | ** ** |
|--------------------------------|------------|------------------------------------------|------------|
| ** **                     | ** ** | **2006**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
| Dividend yield                 |       | None                                     |       | None |   | None |   |
| Expected  volatility           |       | 80.00                                    |       | 80.00 |   | 80.00 |   |
| Risk-free  interest rate       |       | 4.14%  - 4.72%                           |       | 4.17%  - 4.73% |   | 3.38%  - 4.40% |   |
| Expected life                  |       | 10  years                                |       | 10  years |   | 10  years |   |
| Fair value of options  granted |       | $1.99                                    |       | $2.61 |   | $1.64 |   |

 

*Fair Value of FinancialInstruments*

Thefair value of cash and cash equivalents, receivables and payables at March 31,2006 and 2005 approximate their carrying amount due to the short maturities ofthese items. Financial instruments that potentially subject the Company to aconcentration of credit risk principally consist of cash and cash equivalentsand trade receivables.

Allof the Company’s cash and cash equivalents are maintained at major financialinstitutions.

The Companyperforms ongoing credit evaluations of the financial condition of its customersand generally does not require collateral. The Company’s private label medicaldevice manufacturing division requires new customers to pay a deposit prior toany work being performed, which is recorded as deferred revenue. Although theCompany is directly affected by the overall financial condition of thehealthcare industry, management does not believe significant credit risk existsat March 31, 2006 and 2005. The Company maintains an allowance fordoubtful accounts based on accounts past due according to contractual terms andhistorical collection experience. Actual losses when incurred are charged tothe allowance.

*Reclassifications*

Certain amounts in the 2005 and 2004 financialstatements were reclassified to conform to the 2005 presentation.

*Recent AccountingPronouncements*

TheFASB issued Statement 123R, “Share-Based Payment,” which requires all companiesto measure compensation cost for all share-based payments, including employeestock options, at fair value, effective for public companies (except smallbusiness issuers as defined in SEC Regulation S-B) for interim or annualperiods beginning after December 15, 2005. Retroactive application of therequirements of SFAS No. 123 (“SFAS 123”), “Accounting for Stock-BasedCompensation,” not Statement 123R, to the beginning of the fiscal year thatincludes the effective date would be permitted, but not required and earlyadoption of Statement 123R is encouraged. The FASB has concluded that companiescould adopt the new standard in one of two ways. First, under the modifiedprospective transition method, a company would recognize share-based employeecompensation cost from the beginning of the fiscal period in which therecognition provisions are first applied as if the fair-value-based accountingmethod had been used to account for all employee awards granted, modified, orsettled after the effective date and to any awards that were not fully vestedas of the effective date. Measurement and attribution of compensation cost forawards that are nonvested as of the effective date of the proposed Statementwould be based on the same estimate of the grant-date fair value and the sameattribution method used previously under SFAS 123 (either for recognition orpro forma purposes). Second, under the modified retrospective transitionmethod, a company would recognize employee compensation cost for periodspresented prior to the adoption of Statement 123R in accordance 

F-11

----

 

**CARDIOTECH INTERNATIONAL, INC.**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

with the original provisions of SFAS 123; that is, anentity would recognize employee compensation cost in the amounts reported inthe pro forma disclosures provided in accordance with SFAS 123. A company wouldnot be permitted to make any changes to those amounts upon adoption of theproposed Statement unless those changes represent a correction of an error (andare disclosed accordingly). For periods after the date of adoption of Statement123R, the modified prospective transition method described above would beapplied. The Company is still in the process of determining the impact of thisstatement on the consolidated financial statements, but believes the impactwill be minimal given the acceleration of options and the small number ofunvested options that remain outstanding.

**B.**            RelatedParty Transactions

TheCompany has an investment in CorNova, Inc., of which Dr. Eric Ryan isPresident and a major shareholder. The Company, on July 15, 2004, enteredinto a two-year consulting agreement with Dr. Ryan, which provides for arange of payments, in either cash or common stock, for the achievement ofcertain milestones related to the manufacturing, commencement of Europeanclinical trials and the receipt of a restricted CE mark of the Company’sCardioPass synthetic coronary artery bypass graft. Total potential paymentsrange from $125,000 to $216,000 based on the timing of the milestoneachievements. As part of the agreement, Dr. Ryan has the opportunity toearn up to an additional $56,000 based on the achievement of certain milestonesrelated to other products of the Company. At March 31, 2006 and 2005,several of the contract milestones had been achieved and, accordingly, coststotaling $38,000 and $73,000 related to performance under this contract havebeen recognized as a research and development expense for the years ended March 31,2006 and 2005, respectively. There were no research and development expensesrecognized during the year ended March 31, 2004 related to this agreement.

In December 1998,certain executive officers of the Company purchased, in the aggregate, 160,000units as part of the Fechtor Detwiler 1998 private placement offering of theCompany’s common stock and warrants exercisable until December 15, 2003 topurchase the Company’s common stock. A note in the aggregate principal amountof $200,000 issued by these officers to the Company funded the purchase of theunits. The terms of the note provided for each executive to repay the note withinterest at 4.25% per annum, within five years. The promissory notes, whichwere full recourse against the maker with respect to any amount due under thepromissory notes, were secured by the common stock and warrants underlying theunits. The principal balance outstanding of $150,000 was due on December 15,2003. The Company received notification from a former officer and a currentboard member of their intention to exercise the warrants prior to December 15,2003. Their payments for the exercise of the warrants were received after the December 15,2003 expiration date, however the Company allowed for the exercise of thosewarrants. This effective modification of the warrants resulted in a non-cashcompensation expense of $344,000. In applying generally accepted accountingprinciples (GAAP), the acceptance of the late payments on the warrant exerciserepresents a modification of the award and is treated as if a new award wasgranted on the date of modification. The intrinsic value of the awards on thedate of the modification was recorded as non-cash compensation expense in theaccompanying statement of operations.

EffectiveJune 18, 2003, the Company and one of the Company’s consultants executed afull recourse promissory note for $26,250 related to the exercise of stockoptions bearing interest at 6% with payments due monthly as the sharesexercised are sold. During the quarter ended September 30, 2003 theconsultant paid this promissory note and all related interest in full.

In July 1999,Dermaphylyx International, Inc., a related party, was formed by certainaffiliates of CardioTech to develop advanced wound healing products. Dermaphylyxwas merged into CardioTech International, Inc., pursuant to which itbecame a wholly owned subsidiary of CardioTech. Due to CardioTech’s controllingfinancial interest, Dermaphylyx has been consolidated in the financialstatements of CardioTech as of December 31, 2003. Prior to December 31,2003, the operations and total assets of Dermaphylyx were not material toCardioTech. Since July 1999, the year Dermaphylyx was incorporated, alldevelopment expenses have been paid by CardioTech International, Inc. Uponthe merger, the current shareholders of Dermaphylyx received 3,827 shares ofcommon stock of CardioTech valued at the net book value of DermaphylyxInternational, Inc., as of December 31, 2003, which was approximately$21,000. See Note S.

**C.****            LicenseAgreements**

PolyMedicaCorporation (NASDAQ: “PLMD”) granted to CardioTech an exclusive, perpetual,worldwide, royalty-free license for CardioTech to use all of the necessarypatent and other intellectual property owned by PLMD in the implantable devicesand materials field (collectively, “PLMD Licensed Technology”). CardioTech, atits own expense, will file patents or other applications for the protection ofall new inventions formulated, made, or 

F-12

----

 

**CARDIOTECH INTERNATIONAL, INC.**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

conceived by CardioTech during the term of the licensethat related to PLMD Licensed Technology and all such inventions shall beexclusively licensed to PLMD for use by PLMD in fields other than theimplantable devices and materials field. There are no financial commitments ofCardioTech related to this license.

**D.**            Property andEquipment

**Property and equipmentconsists of the following:**
| ** **                                       | ** ** | **March 31,** | ** ** |
|--------------------------------------------------|------------|--------------------|------------|
| ***(in thousands)***                        | ** ** | **2006**           | ** ** | **2005** | ** ** |
| Land                                             |       | $                  | 500        |   | $ | 500 |   |
| Building                                         |       | 2,053              |       | 2,030 |   |
| Machinery,  equipment and tooling                |       | 2,473              |       | 2,401 |   |
| Furniture,  fixtures and office equipment        |       | 651                |       | 541 |   |
| Leasehold  improvements                          |       | 1,336              |       | 1,292 |   |
|                                             |       | 7,013              |       | 6,764 |   |
| Less:  accumulated depreciation and amortization |       | (2,954             | )          | (2,215 | ) |
|                                             |       | $                  | 4,059      |   | $ | 4,549 |   |

 

**Depreciationexpense for property and equipment for the fiscal years ended March 31,2006, 2005 and 2004 was approximately $798,000, $824,000 and $900,000,respectively.**

**E.**              Income Taxes

Reconciliation between the Company’s effective taxrate and the United States statutory rate is as follows:
| ** **                                      | ** ** | **For The Years  Ended March 31,** | ** ** |
|-------------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                                      | ** ** | **2006**                                               | ** ** | **2005** | ** ** | **2004** | ** ** |
| Expected federal  tax rate                      |       | 34.0                                                   | %          | 34.0 | % | 34.0 | % |
| State income  taxes, net of federal tax benefit |       | 4.2                                                    | %          | 4.4 | % | 5.0 | % |
| Non-deductible  expenses                        |       | (9.3                                                   | )%         | (1.0 | )% | (17.0 | )% |
| Deductible stock  compensation                  |       | 1.9                                                    | %          | 0.0 | % | 0.0 | % |
| Change in  valuation allowance                  |       | (30.8                                                  | )%         | (37.4 | )% | (22.0 | )% |
| Effective tax  rate                             |       | 0.0                                                    | %          | 0.0 | % | 0.0 | % |

 

Deferred taxassets and liabilities are determined based on the differences between thefinancial statement carrying amounts and the tax basis of the assets andliabilities using the enacted tax rate in effect in the years in which thedifferences are expected to reverse. A valuation allowance has been recordedagainst the deferred tax asset as it is more likely than not, based upon an analysisby the Company of all available evidence, that the tax benefit of the deferredtax asset will not be realized. Significant components of the Company’s deferredtax assets and deferred tax liabilities as of March 31, 2006 and 2005 consistedof the following:
| ** **                                                             | ** ** | **March 31,** | ** ** |
|------------------------------------------------------------------------|------------|--------------------|------------|
| ***(in thousands)***                                              | ** ** | **2006**           | ** ** | **2005** | ** ** |
| ***Deferred  Tax Assets:***                                            |       |               |       |   |   |
| Net operating  loss carryforwards                                      |       | $                  | 10,413     |   | $ | 9,525 |   |
| Tax credits                                                            |       | 135                |       | 71 |   |
| Inventory and  receivable allowances                                   |       | 542                |       | 540 |   |
| Accrued expenses  deductible when paid                                 |       | 387                |       | 360 |   |
| Depreciation and  amortization                                         |       | 134                |       | 141 |   |
| Deferred tax assets                                                    |       | 11,611             |       | 10,637 |   |
|                                                                   |       |               |       |   |   |
| ***Deferred  Tax Liabilities:***                                       |       |               |       |   |   |
| Basis difference  in equity investment in CorNova                      |       | (39                | )          | — |   |
| Deferred tax  liability on basis difference of amortizable intangibles |       | (195               | )          | (264 | ) |
| Deferred tax  liabilities                                              |       | (234               | )          | (264 | ) |
|                                                                   |       |               |       |   |   |
| Sub-total                                                              |       | 11,377             |       | 10,373 |   |
| Valuation  allowance                                                   |       | (11,377            | )          | (10,373 | ) |
| Net deferred tax asset                                                 |       | $                  | —     |   | $ | — |   |

 

Asof March 31, 2006, the Company had federal and state net operating losscarry forwards of approximately $26,915,000 and $20,124,000, respectively,available to offset future taxable income, that expire between 2008 through 2026.Approximately $11,349,000 of the Federal net operating loss carry forwards issubject to annual limitations as a result of the change in control of Gish. Asof March 31, 2006, the Company had federal and state tax creditcarryforwards of approximately $66,000 and $101,000, respectively, available tooffset future taxable income, that expire between 2007 and 2026.

F-13

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**CARDIOTECH INTERNATIONAL, INC.**

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**F.   Concentration ofCredit Risk and Major Customers**

Financialinstruments that potentially subject the Company to significant concentrationsof credit risk consist principally of cash and cash equivalents and tradeaccounts receivable. The Company maintains cash and cash equivalents with highcredit, quality financial institutions. To manage accounts receivable creditrisk, the Company continuously evaluates the creditworthiness of its customersand maintains allowances for potential credit losses. As of March 31, 2006and 2005, the Company believes it has no significant concentration of creditrisk. One sales representative organization comprised 5%, 4% and 2% of theCompany’s revenues in fiscal 2006, 2005 and 2004, respectively.

**G.   Commitments**

Aggregate future minimum rental payments requiredunder operating leases for the Rancho Santa Margarita, Irvine, and Plymouthfacilities are as follows:
| **Fiscal Years Ended March 31,(in thousands)** | ** ** | **Rancho Santa  Margarita, CA** | ** ** | **Irvine, CA** | ** ** | **Plymouth, MN** | ** ** |
|-------------------------------------------------------------------------|------------|-------------------------------------------|------------|---------------------|------------|-----------------------|------------|
| 2007                                                                    |       | $                                         | 477        |                | $          | 158                   |       | $ | 131 |   |
| 2008                                                                    |       | 491                                       |       | 163                 |       | 131                   |       |
| 2009                                                                    |       | 506                                       |       | 169                 |       | 131                   |       |
| 2010                                                                    |       | 521                                       |       | 174                 |       | —                |       |
| 2011                                                                    |       | 445                                       |       | —              |       | —                |       |
| Thereafter                                                              |       | —                                    |       | —              |       | —                |       |
|                                                                    |       | $                                         | 2,440      |                | $          | 664                   |       | $ | 393 |   |

 

Rentexpense charged to operations was $761,000, $732,000 and $786,000 for the yearsended March 31, 2006, 2005 and 2004, respectively.

TheCompany also has purchase commitments totaling approximately $1.9 million at March 31,2006 related to outstanding noncancelable purchase orders for raw materials.

**H.   Revolving Line ofCredit**

Whenacquired, Gish had a $4,000,000 revolving line of credit, expiring in February 2005.Advances, based on eligible receivables, were secured by the operating assetsof Gish and bear interest at prime plus 2%. The agreement also included variousrestrictive loan covenants, including a requirement for Gish to maintain aminimum net worth of $7,000,000 and to achieve positive net income on a rollingthree-month basis.

At March 31,2006, the Company had no outstanding balance due under the revolving line ofcredit, as the revolving line of credit agreement was terminated by the Companyin January 2005.

**I.   Stockholders’Equity**

***Common Stock Options and Warrants***

On December 22,2004, the Company issued 1,139,586 shares of its common stock at $2.40 pershare in a private placement receiving approximately $2,735,000 in grossproceeds, less placement agent fees and related transaction costs ofapproximately $314,000.

Inconnection with the transaction, the Company issued warrants to the investorsto purchase 569,793 shares of common stock at an exercise price of $3.00 pershare, which are exercisable until December 22, 2009. In addition, theinvestors had rights to purchase up to 1,139,586 shares of common stock at aprice of $2.40 per share, which were exercisable for a period commencing on December 22,2004 and ending on July 24, 2005. We also issued warrants to the placementagent to purchase 113,959 shares of our common stock at an exercise price of$2.40 per share and 56,979 shares of our common stock at an exercise price of$3.00 per share, 

F-14

----

**CARDIOTECHINTERNATIONAL, INC.**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

which are exercisable until December 22, 2009. Ifall warrants s are exercised, the Company would receive gross proceeds ofapproximately $2,490,000, less related transaction costs.

Thefair market value of the warrants and additional investment rights granted wasestimated to be $1,606,000 and $768,000 on the date of grant, respectively. Thefair market value of the warrants and additional investment rights granted weredetermined by estimating the fair market value using the Black-Scholes optionvaluation method with the following weighted average assumptions: dividendsyield-none; expected volatility-80%; risk free interest rate 3.60%-5yr. rate in December 2004; expected life-5 years; fair value ofoptions granted-$0.67 (additional investment rights)-$1.59 ($2.40warrants)-$1.99 ($3.00 warrants).

TheCompany issued 543,254 shares of common stock during the year ended March 31,2006, as a result of the exercise of options by employees and consultants,generating cash proceeds of $1,246,000. The Company issued 179,501 shares ofcommon stock during the year ended March 31, 2005, as a result of theexercise of options by employees and consultants, generating cash proceeds of$254,000. The Company issued 2,354,190 shares of common stock during year endedMarch 31, 2004, as a result of the exercise of options by employees andconsultants, generating cash proceeds of $4,984,000 and issued 1,158,900 sharesof common stock as a result of the exercise of warrants, generating cashproceeds of $1,770,000.

Duringthe 2005 fiscal year, the Company recorded non-cash compensation expense forinvestment advisory services of $58,000 related to options granted to purchase100,000 shares of the Company’s common stock at an exercise price of  $3.50, expiring September 2006. The compensation expense was determined byestimating the fair market value of the options granted by using theBlack-Scholes option valuation model with the following weighted averageassumptions; dividends yield-none; expected volatility-80%; risk-freeinterest rate-4.52%; expected life-18 months.

Duringthe 2004 fiscal year, the Company recorded non-cash compensation expense of$92,000 related to options granted to non-employees. The compensation expense was determined by estimating the fair market valueof the options granted by using the Black-Scholes option valuation model withthe following weighted average assumptions; dividends yield-none; expectedvolatility-80%; risk-free interest rate-2.84% - 4.27%; expectedlife-10 years. On November 26, 2003, the Company concluded a jointresearch project with Implant Sciences Corporation (Implant) which awardedImplant the right to purchase 40,000 shares of the Company’s common stock at$1.00 a share. This award resulted in a non-cash expense of $210,000 in fiscalyear 2005 to record the excess of the fair value of the award. The fair valueof the award was based on the closing market price of the Company’s commonstock at the date of grant.

On January 26,2004, the Board of Directors of CardioTech retained a consultant for a periodof six months to continue to represent CardioTech to the investment community. Servicesto be performed are 1) create greater awareness in the brokerage community forCardioTech and, 2) to advise CardioTech on market conditions. Fees for theseservices will include (a) all pre-approved out-of-pocket expenses, and (b) theperiodic grant of stock options in tranches, up to a maximum aggregate grant of1,000,000 shares. The options will have an exercise price equal to 75% of theclosing price for the day prior to the date of each grant, and will expirethree months from the grant date. This agreement may be renewed by the mutualconsent of the parties hereto at such terms as shall be mutually agreed to bythe parties. During the three-month period ended March 31, 2004, theCompany granted options under this consulting agreement to purchase 150,000shares. The consultant exercised the options during the three-month periodended March 31, 2004 and proceeds from the exercise of these optionstotaled $697,000. The Company has recorded an expense of $232,000 for thedifference between the proceeds received and the fair market value of theoptions on the date of grant. During the fiscal year ended March 31, 2003,the Company wrote-off a note receivable from this consultant for $280,000 as itdeemed it uncollectible at that time. The Company reasoned that this notereceivable was over two years old, therefore it was appropriate to record theexpense during the fiscal year ended March 31, 2002. The note wasoriginally issued by the Company for the exercise of 200,000 options topurchase shares of common stock. The Company received payments totaling$237,000 during fiscal 2004, which have been recorded as other income in theaccompanying consolidated statement of operations. The Consultant remainsobligated to the Company for the remaining $23,000 as of March 31, 2006,which continues to be fully reserved for by the Company. During fiscal 2004,the Consultant exercised options, granted (at the fair market value on the dateof grant) and vested in fiscal years prior to fiscal 2004, for 1,000,000 sharesat a total purchase price of $2,695,000. The formal agreement with theConsultant expired January 25, 2005.

F-15

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**CARDIOTECH INTERNATIONAL, INC.**

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

Nooptions were granted to the Consultant in fiscal 2005.

Infiscal 2006, the Company granted the Consultant fully vested options totaling240,000 shares with expirations of one month after the grant dates for servicesas described above. During fiscal 2006, the Consultant exercised the same240,000 options and the Compay received proceeds totaling $607,000. The Companyhas recorded an expense of $193,000 for the difference between the proceedsreceived and the fair market value of the options on the date of grant.

***Treasury Stock and other transactions***

In June 2004,the Board of Directors authorized the purchase of up to 500,000 additionalshares of the Company’s common stock. In June 2001, the Board of Directorsauthorized the purchase of up to 250,000 shares of the Company’s common stockof which 168,677 shares have been purchased at March 31, 2005, including24,000 purchased during the year ended March 31, 2005. During fiscal 2006,the Company purchased 5,410 shares for approximately $12,100. The Companyannounced that purchases may be made from time-to-time in the open market,privately negotiated transactions, block transactions or otherwise, at timesand prices deemed appropriate by management.

EffectiveJuly 1, 2004, companies incorporated in Massachusetts became subject tothe Massachusetts Business Corporation Act, which provides that shares that arereacquired by a company  becomeauthorized but unissued shares. As a result, the concept of “treasury shares”is eliminated and shares reacquired by a company become “authorized butunissued” shares. Accordingly, the Company has reclassified treasury stock at March 31,2005 as a reduction of common stock at the par value amount of $.01 share andthe excess of the cost of the treasury stock over the par value has beenrecorded as a reduction of additional paid-in capital. At March 31, 2005,68,677 shares of treasury stock with a cost of $266,000 have been soreclassified.

Duringthe second quarter of fiscal 2004, the Company issued 95,000 treasury shares tovarious employees and board members for their effort in the Gish transaction. Thefair market value of these treasury shares was approximately $293,000, whichwas recorded as a non-cash compensation expense in the Consolidated Statementof Operations for the 2004 fiscal year. Subsequently, two board membersreturned the stock to the Company. The 10,000 shares returned were recorded atthe fair market value on December 9, 2003 by increasing additional paid incapital and treasury stock by $68,000. Thefair market value was based upon the closing stock price of the Company’scommon stock at the date of grant.

Duringthe 2004 fiscal year, the Company received $150,000 in payments on officernotes, which had been included in subscription receivable from related parties.During the 2004 fiscal year, the Company recorded additional subscriptionreceivable of $140,000 due to the issuance of stock to holders of options andwarrants, prior to receiving payment of the related exercise price. Theirpayments for the exercise of the warrants were received after the December 15,2003 expiration date, however the Company allowed for the exercise of thosewarrants. During the fourth quarter of fiscal 2004, these subscriptionreceivables were paid in full.

**J.   Enterprise andRelated Geographic Information**

TheCompany acquired Gish Biomedical, Inc. effective April 7, 2003 andsubsequent to that date, the Company has managed its business in fiscal 2006,2005 and 2004 on the basis of one reportable operating segment, Medical DeviceManufacturing and Sales, in accordance with the qualitative and quantitative criteriaestablished by SFAS 131, “Disclosures about Segments of an Enterprise andRelated Information.”

Salesto foreign customers (primarily Europe and Asia) aggregated approximately$3,228,000, $3,676,000 and $3,247,000 in 2006, 2005 and 2004, respectively. TheCompany has no long-lived assets outside of the United States.

F-16

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**CARDIOTECH INTERNATIONAL, INC.**

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**Revenuesfor the presented periods are as follows:**
| ** **                                 | ** ** | **For The Years Ended March 31,** | ** ** |
|--------------------------------------------|------------|------------------------------------------------------------|------------|
| **(in thousands)**                    | ** ** | **2006**                                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Medical devices                            |       | $                                                          | 20,411     |   | $ | 19,530 |   | $ | 19,991 |   |
| Contracted  product design and development |       | 993                                                        |       | 1,537 |   | 1,332 |   |
| Royalties                                  |       | 977                                                        |       | 774 |   | 476 |   |
|                                       |       | $                                                          | 22,381     |   | $ | 21,841 |   | $ | 21,799 |   |

 

**K.   SupplementalDisclosures for Stock-Based Compensation**

CardioTech’s1996 Employee, Director and Consultants Stock Option Plan (the “1996 Plan”) wasapproved by CardioTech’s Board of Directors and Stockholders in March 1996.A total of 7,000,000 shares have been reserved for issuance under the Plan. Underthe terms of the Plan the exercise price of Incentive Stock Options issuedunder the Plan must be equal to the fair market value of the common stock atthe date of grant. In the event that Non Qualified Options are granted underthe Plan, the exercise price may be less than the fair market value of thecommon stock at the time of the grant (but not less than par value). In October 2003,the Company’s shareholders approved the CardioTech International, Inc. 2003Stock Option Plan (the “2003 Plan”), which authorizes the issuance of 3,000,000shares of common stock with terms similar to the 1996 Plan. In January, 2006,the Company filed Form S-8 with the Securities and ExchangeCommission registering an addition 489,920 shares of common stock in the 1996Plan and 2003 Plan. Total shares of common stock registered for the 1996 Planand 2003 Plan are 10,489,920. Substantially all of the stock options grantedpursuant to the 1996 Plan provide for the acceleration of the vesting of theshares of Common Stock subject to such options in connection with certainchanges in control of the Company. A similar provision is not included the 2003Plan. Normally options granted expire ten years from the grant date.

Activity under the Plans for the years ended March 31,  2006, 2005 and 2004 is as follows:
| ** **                          | ** ** | **2006**                    | ** ** | **2005**                               | ** ** | **2004**                    | ** ** |
|-------------------------------------|------------|-----------------------------|------------|----------------------------------------|------------|-----------------------------|------------|
| ** **                          | ** ** | **Number of  Options** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number of  Options** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number of  Options** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| Outstanding at  beginning of period |       | 6,590,035                   |       | $                                      | 2.30       |                        | 4,844,848  |   | $ | 1.97 |   | 4,373,222 |   | $ | 1.67 |   |
| Granted                             |       | 730,834                     |       | 3.11                                   |       | 2,073,500                   |       | 3.13 |   | 2,880,304 |   | 2.45 |   |
| Cancelled                           |       | (566,735                    | )          | 3.55                                   |       | (148,812                    | )          | 4.13 |   | (54,488 | ) | 1.85 |   |
| Exercised                           |       | (543,254                    | )          | 2.33                                   |       | (179,501                    | )          | 1.41 |   | (2,354,190 | ) | 2.11 |   |
| Outstanding at  end of period       |       | 6,210,880                   |       | $                                      | 2.21       |                        | 6,590,035  |   | $ | 2.30 |   | 4,844,848 |   | $ | 1.97 |   |
| Exercisable at end of  period       |       | 6,206,504                   |       | $                                      | 2.20       |                        | 6,590,035  |   | $ | 2.30 |   | 4,048,773 |   | $ | 1.59 |   |

 

Asof March 31, 2006, 2,034,046 shares were issued under the 2003 StockOption Plan and 385,000 options were granted pursuant to Rule 711 of theAmerican Stock Exchange. Under Rule 711, a first-time employee may begranted an option without approval of stockholders if approved by the Company’sBoard of Directors.

F-17

----

**CARDIOTECH INTERNATIONAL, INC.**

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

Summarizedinformation about stock options outstanding at March 31, 2006 is asfollows:
| ** **               | ** ** | ** **         | ** ** | **Weighted**          | ** ** | ** **   | ** ** | **Exercisable**    | ** ** |
|--------------------------|------------|--------------------|------------|-----------------------|------------|--------------|------------|--------------------|------------|
| ** **               | ** ** | ** **         | ** ** | **average**           | ** ** | **Weighted** | ** ** | ** **         | ** ** | **Weighted** | ** ** |
| ** **               | ** ** | **Number of** | ** ** | **remaining**         | ** ** | **average**  | ** ** | ** **         | ** ** | **average** | ** ** |
| **Range of**        | ** ** | **options**        | ** ** | **contractual**       | ** ** | **exercise** | ** ** | **Number of** | ** ** | **exercise** | ** ** |
| **exercise prices** | ** ** | **outstanding**    | ** ** | **life (years)** | ** ** | **price**    | ** ** | **options**        | ** ** | **price** | ** ** |
| $0.50 - $0.92            |       | 1,450,580          |       | 6.2                   |       | $            | 0.86       |               | 1,450,580  |   | $ | 0.86 |   |
| $1.10 - $1.94            |       | 1,761,275          |       | 4.2                   |       | 1.53         |       | 1,761,275          |       | 1.53 |   |
| $2.06 - $2.60            |       | 1,662,225          |       | 8.6                   |       | 2.52         |       | 1,662,225          |       | 2.52 |   |
| $2.73 - $3.94            |       | 381,800            |       | 6.7                   |       | 3.20         |       | 377,424            |       | 3.20 |   |
| $4.04 - $5.40            |       | 955,000            |       | 7.8                   |       | 4.57         |       | 955,000            |       | 4.57 |   |
| $0.50 - $5.40            |       | 6,210,880          |       | 6.5                   |       | $            | 2.21       |               | 6,206,504  |   | $ | 2.20 |   |

 

At March 31,2006 there were no shares remaining to be granted under the 1996 Stock OptionPlan and 965,954 shares were available for grant under the 2003 Stock OptionPlan.

At March 31,2006, warrants issued to purchase 880,731 shares of common stock wereoutstanding. Warrants for 140,000 shares of common stock have an exercise priceof $2.40 and expire on July 11, 2008. Warrants for 740,731 shares ofcommon stock have an exercise price of $3.00 and expire on December 22,2009.

Theexecutive compensation structure that the compensation committee of the Boardof Directors for the Gish transaction approved provided for a stock optiongrant to Dr. Michael Szycher that ensured that Dr. Michael Szycher’spercentage of ownership (20.8%) would be the same after the Gish transaction asit was before. In fiscal 2004, upon completion of the Gish transaction, MichaelSzycher was granted a stock option for 1,017,330 shares at an exercise price of$0.92 per share. Similar awards may be granted in the future for acquisitionsor equity based transactions.

**L.**             IntangibleAssets

Amortizable intangible assets consist of thefollowing:
| ** **                          | ** ** | ** **           | ** ** | **March 31,** | ** ** |
|-------------------------------------|------------|----------------------|------------|--------------------|------------|
| *** ***                        | ** ** | **Estimated**        | ** ** | ** **         | ** ** | ** ** | ** ** |
| *** ***                        | ** ** | **Useful Life** | ** ** | ** **         | ** ** | ** ** | ** ** |
| **(in thousands)**             | ** ** | **in Years**    | ** ** | **2006**           | ** ** | **2005** | ** ** |
| Customer  intangibles               |       | 5 to 7               |       | $                  | 1,056      |   | $ | 1,056 |   |
| Technology  intangibles             |       | 15                   |       | 262                |       | 262 |   |
|                                |       |                 |       | 1,318              |       | 1,318 |   |
| Less:  accumulated amortization     |       |                 |       | (734               | )          | (542 | ) |
| Amortizable intangible  assets, net |       |                 |       | $                  | 584        |   | $ | 776 |   |

 

Goodwill consists of the following:
| ** **                                            | ** ** | **March 31,** | ** ** |
|-------------------------------------------------------|------------|--------------------|------------|
| **(in thousands)**                               | ** ** | **2006**           | ** ** | **2005** | ** ** |
| Goodwill                                              |       | $                  | 2,367      |   | $ | 2,367 |   |
| Less:  accumulated amortization                       |       | (728               | )          | (729 | ) |
| Less: write-off  for goodwill impairment (See Note A) |       | (1,152             | )          | — |   |
| Goodwill                                              |       | $                  | 487        |   | $ | 1,638 |   |

 

**M.**          OtherAgreements

In March 2000,Implant Sciences Corporation (AMEX:IMX) entered into a $250,000 joint researchagreement with the Company for the purpose of having the Company develop aproprietary porous polymer biocompatible coating technology as a platform forImplant’s proprietary radioactive brachytherapy technology. During fiscal 2001,the Company was paid $50,000 by 

F-18

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**CARDIOTECH INTERNATIONAL, INC.**

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

Implant pursuant to the aforementioned agreement. Thejoint research and development agreement provides for the Company to developthe polyurethane coating instrumental in the development of a polyurethanecoated drug-eluting stent and for the Company to grant Implant a perpetualworldwide exclusive license to use, sublicense and otherwise deal in anytechnology developed by the Company in connection with the development of thestents. In consideration of the research, development and technology transfer,Implant paid the Company $150,000 in cash pursuant to a milestone schedule. Inaddition, Implant agreed to purchase 100,000 shares of CardioTech’s commonstock at a price of $1.00 per share upon the achievement of certain milestonesspecified in the agreement. On April 18, 2002, Implant purchased 60,000shares of the Company’s common stock at $1.00 per share. On November 26,2003, Implant purchased 40,000 shares of the Company’s common stock at $1.00per share.

Theowner of the technology used in connection with the stent will be CardioTech;however, such technology will be transferred to Implant pursuant to atechnology license. The developed technology represents a “platform” in thesense that the polyurethane developed by CardioTech and utilized to cover thestent will be the medium in which specific anti-restenosis drugs will beimplanted and therefore becomes the key technological component of thisdrug-eluting stent. The research and development agreement provides for 6phases including the design of equipment necessary to produce prototypes of thestent, development of a series of prototypes, production of a limited number ofprototypes and the delivery of prototypes to Implant. The material deadline istherefore the delivery of an operative prototype.

On November 26,2003, Implant accepted the Company’s final report covering the joint researchprogram on developing a drug-eluting stent. On November 26, 2003, Implantpaid the Company $75,000; $35,000 was the final payment on the research programand $40,000 was payment for the purchase of 40,000 shares of the Company’scommon stock at the price of $1.00 per share. The issuance of 40,000 shares ofthe Company’s common stock to Implant resulted in a non-cash expense ofapproximately $210,000. The excess of the fair value of the total award on November 26,2003 was recorded as non-cash research and development expense and included inthe accompanying statement of operations. As of November 26, 2003, Implanthas paid the Company the entire $250,000 due under this joint researchagreement. Implant and the Company have no further obligations under thisagreement.

**N.**            Valuationand Qualifying Accounts
| **(in thousands)**          | ** ** | **Balance at  beginning of  period** | ** ** | **Charged to  costs and  expenses** | ** ** | **Other** | ** ** | **Write-off** | ** ** | **Balance at  end of  period** | ** ** |
|----------------------------------|------------|------------------------------------------------|------------|-----------------------------------------------|------------|-----------|------------|---------------|------------|------------------------------------------|------------|
| Year ended  March 31, 2006: |       |                                           |       |                                          |       |      |       |          |       |                                     |       |
| Deducted from assets accounts:   |       |                                           |       |                                          |       |      |       |          |       |                                     |       |
| Allowance for doubtful accounts  |       | $                                              | 326        |                                          | $          | 249       |       | $             | (2         | )                                        | $          | (1 | ) | $ | 572 |   |
| Excess and obsolescence reserve  |       | 402                                            |       | 642                                           |       | —    |       | (62           | )          | 982                                      |       |
| Total                            |       | $                                              | 728        |                                          | $          | 893       |       | $             | (2         | )                                        | $          | (63 | ) | $ | 1,554 |   |
| Year ended  March 31, 2005: |       |                                           |       |                                          |       |      |       |          |       |                                     |       |
| Deducted from  assets accounts:  |       |                                           |       |                                          |       |      |       |          |       |                                     |       |
| Allowance for doubtful accounts  |       | $                                              | 201        |                                          | $          | 202       |       | $             | 7          |                                     | $          | (84 | ) | $ | 326 |   |
| Excess and obsolescence reserve  |       | 372                                            |       | 115                                           |       | —    |       | (85           | )          | 402                                      |       |
| Total                            |       | $                                              | 573        |                                          | $          | 317       |       | $             | 7          |                                     | $          | (169 | ) | $ | 728 |   |
| Year ended  March 31, 2004: |       |                                           |       |                                          |       |      |       |          |       |                                     |       |
| Deducted from  assets accounts:  |       |                                           |       |                                          |       |      |       |          |       |                                     |       |
| Allowance for doubtful accounts  |       | $                                              | 92         |                                          | $          | 24        |       | $             | 80         |                                     | $          | 5 |   | $ | 201 |   |
| Excess and obsolescence reserve  |       | 15                                             |       | 48                                            |       | 472       |       | (163          | )          | 372                                      |       |
| Total                            |       | $                                              | 107        |                                          | $          | 72        |       | $             | 552        |                                     | $          | (158 | ) | $ | 573 |   |

** **

F-19

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**CARDIOTECHINTERNATIONAL, INC.**

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

**O.**           Benefit Planand Employment Agreements

TheCompany has several Salary Reduction Profit Sharing Plans (“the Plans”),established under Section 401(k) of the Internal Revenue Code.  All full time employees who are eighteen yearsof age and have completed 30 days of employment are eligible to participate. TheCompany’s contributions are discretionary and the Company made no matchingcontributions in 2006, 2005 and 2004. An annual Company contribution to thePlans was $21,000 in 2006 and $27,000 in both fiscal 2005 and  2004.

TheCompany has entered into an employment agreement (the “Szycher Agreement”) withDr. Michael Szycher, pursuant to which said individual serves as ChiefExecutive Officer of the Company. Pursuant to the terms of the SzycherAgreement, Dr. Szycher is to receive an annual base salary of ThreeHundred and Twenty Five Thousand ($325,000) dollars. Dr. Szycher’s salarywill be reviewed annually by the Board. Additionally, Dr. Szycher may alsobe entitled to receive an annual bonus payment in an amount, if any, to bedetermined by the Compensation Committee of the Board.

Theinitial term of the Szycher Agreement by and between the Company and Dr. Szycherwas set to expire on December 31, 2004, however, in fiscal 2005, theagreement was extended until December 31, 2007. After such time, the termof the Employment Agreement will be deemed to continue on a month-to-monthbasis if not expressly extended while Dr. Szycher remains employed by theCompany. Dr. Szycher and CardioTech each have the right to terminate theSzycher Agreement at any time, with or without cause (as defined in the SzycherAgreement), upon thirty (30) days prior written notice. In the event thatCardioTech terminates the applicable Szycher Agreement without cause, or Dr. Szycherterminates his employment for good reason following a change in control (assuch terms are defined in the Employment Agreement) or CardioTech fails torenew the Szycher Agreement within two (2) years following the occurrenceof a change in control, Dr. Szycher will be entitled to receive severanceequal to 2.99 times his annual base salary at termination. In such event, Dr. Szycherwill be bound by a noncompete covenant for one (1) year followingtermination of his employment

TheCompany has entered into an employment agreement (the “Walters Agreement”) withEric G. Walters, pursuant to which said individual serves as Vice President andChief Financial Officer of the Company. Pursuant to the terms of the WaltersAgreement, Mr. Walters is to receive an annual base salary of One HundredSeventy Five Thousand ($175,000) dollars. Mr. Walters salary will bereviewed annually by the Board. Additionally, Mr. Walters may also beentitled to receive an annual bonus payment in an amount, if any, to bedetermined by the Compensation Committee of the Board.

Theterm of the Walters Agreement by and between the Company and Mr. Waltersis set to expire on April 1, 2008. After such time, the term of theWalters Agreement will be deemed to continue on a month-to-month basis if notexpressly extended while Mr. Walters remains employed by the Company.Mr. Walters and CardioTech each have the right to terminate the WaltersAgreement at any time, with or without cause (as defined in the WaltersAgreement), upon thirty (30) days prior written notice. In the event thatCardioTech terminates the applicable Walters Agreement without cause, or Mr. Waltersterminates his employment for good reason following a change in control (assuch terms are defined in the Walterst Agreement) or CardioTech fails to renewthe Employment Agreement within two (2) years following the occurrence ofa change in control, Mr. Walters will be entitled to receive severanceequal to 2.0 times his annual base salary at termination. In such event, Mr. Walterswill be bound by a noncompete covenant for one (1) year followingtermination of his employment.

**P.**             Investmentin CorNova, Inc.

AnExchange and Venture Agreement (the “Agreement”) was entered into on March 5,2004 by and among CardioTech, Implant, and CorNova, Inc. (“CorNova”). CorNovais a privately-held, development stage company, incorporated as a Delaware corporation on October 12, 2003.CorNova’s focus is the development of a next-generation drug-eluting stent. On March 5,2004, CardioTech and Implant each agreed to transfer to CorNova 12,931 sharesand 10,344 shares of their common stock (collectively, the “Contributory Shares”),respectively, in exchange for 1,500,000 shares, each, of CorNova’s common stock.The number of Contributory Shares issued reflects the fair market value ofCardioTech’s and Implant’s common stock as of November 18, 2003, for anaggregate value of $75,000 each. This also resulted in CardioTech and Implanteach receiving a thirty percent (30%) ownership interest in CorNova.

Uponthe event of CorNova securing additional financing in the minimum amount of$1,000,000 and up to a maximum amount of $3,000,000 (the “Series AFinancing”), CardioTech and Implant were each required to issue additionalshares of their common stock (the “Investment Shares”), where the number ofInvestment Shares to be issued was equal to twenty-five percent (25%), of thegross 

F-20

----

**CARDIOTECH INTERNATIONAL, INC.**

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

proceeds of the Series A Financing divided by therespective five (5) day average of the closing prices of the common stockof CardioTech and Implant as published in the Wall Street Journal on the datesimmediately preceding the closing of the Series A Financing. CorNova, Inc. completed its Series AFinancing transaction on February 4, 2005. At that time, the Companybecame obligated to contribute shares of its common stock equal to $750,000. Thenumber of shares was determined to be 308,642. The Company has no additionalobligation to contribute assets or additional common stock nor to assume anyliabilities or to fund any losses that CorNova may incur. In addition tothe issuance of its common stock at the completion of a Series AFinancing, CardioTech granted to CorNova an exclusive license for thetechnology consisting of Chronoflex DES polymer, or any poly (carbonate)urethane containing derivative thereof, for use on drug-eluting stents.

Boththe Contributory Shares and the Investment Shares (collectively, the “Securities”)are restricted securities within the meaning of Rule 144 of the Securitiesand Exchange Commission under the Securities Act of 1933, as amended (the “SecuritiesAct”), and none of the Securities may be sold except pursuant to an effectiveregistration statement under the Securities Act or under the securities laws ofany state, or in a transaction exempt from registration under the SecuritiesAct.

The Series AFinancing transaction resulted in the issuance by CorNova of  3,050,000 shares of preferred stock. Thepreferred stock has a liquidation preference equal to $1.00 per share, theoriginal preferred stock purchase price and the same voting rights as CorNova’scommon stock. The CorNova preferred stock can be converted on a share for sharebasis into CorNova common stock at the discretion of the preferred stockholders.The preferred stock is subject to several mandatory conversion requirementsbased on future events and subject to redemption at a premium, which variesbased on the redemption date. CorNova currently also has outstanding warrantsfor the purchase of 150,000 shares of its common stock at $1.00 per share,issued in conjunction with its original seed loans and warrants for thepurchase 635,000 shares of its common stock at $1.10 per share, issued to anindividual as a “finders” fee. Additionally, CorNova’s shareholders haveapproved the 2004 Qualified Incentive Stock Option Plan (“2004 Plan”) whichauthorized the Board of Directors of CorNova to grant options to purchase up to1,000,000 shares of CorNova’s common stock to employees and consultants.

CardioTechhas a 30% ownership interest in the common stock of  CorNova and, accordingly, CardioTech has usedthe equity method of accounting in accordance with APB Opinion No. 18, “TheEquity Method of Accounting for Investments in Common Stock”, and recorded 30%of the net loss of CorNova in its consolidated financial statements for thefiscal years ended March 31, 2006, 2005 and 2004. During fiscal 2006, the Company recorded equity in the net loss ofCorNova of $400,000, and equity in comprehensive income of CorNova of $135,000(related  to unrealized holding gains onsecurities classified as available-for-sale). During fiscal 2005, the Companyrecorded equity in the net loss of CorNova of $113,000, and equity incomprehensive loss of CorNova of $182,000 (related to unrealized holding losseson securities classified as available-for-sale). During fiscal 2004, theCompany recorded equity in the net loss of CorNova of $1,000, equity incomprehensive income of CorNova of $7,000 (related to unrealized holding gainson securities classified as available-for-sale), and recorded a charge of$32,000, reducing its original $75,000 investment to $50,000 at March 31,2004. Because of the liquidation preference of the preferred stock describedabove, if CorNova was liquidated at March 31, 2005, CardioTech would haveincurred an additional loss of its investment of approximately $288,000. The Company has no additional obligation tocontribute assets or additional common stock nor to assume any liabilities orto fund any losses that CorNova may incur.

At March 31,2006, CorNova had total assets of $2,411,000, of which $771,000 was cash andshort-term investments, liabilities totaling $280,000 and stockholders’ equityof $2,132,000 of which $1,716,000 is a retained earnings deficit and $475,000is comprehensive loss related to the decline in market value of the commonstock of CardioTech and Implant Sciences held by CorNova and which wastransferred to CorNova in the transactions discussed above.

**Q.**           TerminatedAcquisition of CarTika Medical, Inc.

On November 19,2004, the Company entered into a definitive agreement (the “Asset PurchaseAgreement”) to acquire substantially all of the assets and assume certainliabilities of CarTika Medical, Inc., a privately owned medical devicecontract manufacturer headquartered in Plymouth, Minnesota (“CarTika”). Thetransaction closing was subject to a variety of closing conditions, including thesuccessful filing of a registration statement covering the shares. Because ofthe protracted time in obtaining regulatory clearance for the acquisition, on June 14,2005, CarTika terminated the proposed acquisition. The Company incurred

F-21

----

**CARDIOTECH INTERNATIONAL, INC.**

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

CarTika related acquisition costs totaling $333,000,which have been charged to expense at March 31, 2005 A net $75,000recovery related to transaction costs incurred and paid in connection with theproposed acquisition of CarTika Medical, Inc. in included in other incomein fiscal 2006.

**R.**               Subsequent Event

On June 6, 2006, theCompany’s Board of Directors decided to wind down the operations ofDermaphylyx, Inc. Total assets of this division were approximately $11,000and the dissolution of the Dermaphylyx business will not have a material effecton the Company’s operations.

**S.**             CondensedConsolidated Quarterly Financial Data (unaudited)

Thefollowing consolidated interim financial information is unaudited. Suchinformation reflects all adjustments, consisting solely of normal recurringadjustments, which are in the opinion of management necessary for a fairpresentation of the quarterly financial data.
| ** **                                                             | ** ** | **Year Ended March 31, 2006** | ** ** |
|------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| **(in thousands, except per share data)**     | ** ** | **Qtr. 1**                                   | ** ** | **Qtr. 2** | ** ** | **Qtr. 3** | ** ** | **Qtr. 4** | ** ** |
| Total revenues                                                         |       | 5,640                                             |       | 6,034 |   | 5,469 |   | 5,238 |   |
| Gross margin                                                           |       | 1,168                                             |       | 1,624 |   | 1,006 |   | 279 |   |
| Net loss                                                               |       | (567                                              | )          | (285 | ) | (958 | ) | (3,259 | ) |
| Net loss per  common share, basic and diluted                          |       | $                                                 | (0.03      | ) | $ | (0.01 | ) | $ | (0.05 | ) | $ | (0.17 | ) |
| Shares used in  computing net loss per common share, basic and diluted |       | 19,258                                            |       | 19,350 |   | 19,499 |   | 19,699 |   |
|                                                                        |            |                                                   |            |  |  |  |  |  |  |  |  |  |  |

 
| ** **                                                            | ** ** | **Year Ended March 31, 2005** | ** ** |
|-----------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| **(in thousands, except per share data)**    | ** ** | **Qtr. 1**                                   | ** ** | **Qtr. 2** | ** ** | **Qtr. 3** | ** ** | **Qtr. 4** | ** ** |
| Total revenues                                                        |       | 5,531                                             |       | 5,289 |   | 5,263 |   | 5,758 |   |
| Gross margin                                                          |       | 1,764                                             |       | 1,485 |   | 1,281 |   | 1,666 |   |
| Net income  (loss)                                                    |       | 51                                                |       | (368 | ) | (652 | ) | (627 | ) |
| Net income  (loss) per common share, basic                            |       | $                                                 | —     |   | $ | (0.02 | ) | $ | (0.04 | ) | $ | (0.03 | ) |
| Net income  (loss) per common share, diluted                          |       | $                                                 | —     |   | $ | (0.02 | ) | $ | (0.04 | ) | $ | (0.03 | ) |
| Shares used in  computing net income (loss) per common share, basic   |       | 17,664                                            |       | 17,671 |   | 17,795 |   | 18,963 |   |
| Shares used in  computing net income (loss) per common share, diluted |       | 20,252                                            |       | 17,671 |   | 17,795 |   | 18,963 |   |

 

Duringthe quarter ended March 31, 2006 the Company tested its intangible assetsfor impairment and based on the results of the first step of the goodwillimpairment test, the Company has determined that the fair value of goodwill ofits cardiopulmonary and private-label medical device manufacturing divisionwere less than the respective carrying amounts and, therefore, goodwillimpairment existed as of March 31, 2006. As a result, the second step ofthe goodwill impairment test was completed and the Company recorded a charge of$598,000 for the impairment of goodwill related to our private-label medicaldevice manufacturing division primarily due to the current cessation of the EndUser as a customer. In addition, there was an additional charge of $554,000 forthe impairment of goodwill for its cardiopulmonary products division due tocontinued reduced demand for these products.

In addition, the Company recorded a $556,000impairment in the fourth quarter of fiscal 2006 for custom inventory held bythe Company related to the End User’s products.

F-22

----

**SIGNATURES**

Pursuant to the requirements of Section 13 or 15(d) ofthe Securities Exchange Act of 1934, as amended, the registrant has duly causedthis report to be signed on its behalf by the undersigned, thereunto dulyauthorized.
| Dated: June 26, 2006 | ** ** | **CardioTech International, Inc.** |
|---------------------------|------------|-----------------------------------------|
|                      | ** ** | ** **                              |   | ** ** |
|                      | ** ** | ** **                              |   | ** ** |
|                      |       | By:                                     |   | /s/ MICHAEL  SZYCHER |
| * *                  |       |                                    |   | Michael Szycher |
| * *                  | * *   | * *                                |   | *Chairman and Chief Executive Officer* |

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, this report has been signed below by the followingpersons on behalf of the registrant and in the capacities and on the datesindicated.
| Dated: June 26, 2006 |   | /s/ MICHAEL  SZYCHER                                                       |   |
|---------------------------|--------|----------------------------------------------------------------------------|--------|
|                      |   | Michael Szycher                                                            |   |
|                      |   | Chairman, Chief Executive Officer  (Principal Executive Officer)           |   |
|                      |   |                                                                       |
| Dated: June 26, 2006 |   | /s/ MICHAEL F.  ADAMS                                                      |   |
|                      |   | Michael F. Adams                                                           |   |
|                      |   | Director, Vice President, Regulatory  Affairs and Business Development     |   |
|                      |   |                                                                       |
| Dated: June 26, 2006 |   | /s/ ANTHONY J.  ARMINI                                                     |   |
|                      |   | Anthony J. Armini                                                          |   |
|                      |   | Director                                                                   |   |
|                      |   |                                                                       |
| Dated: June 26, 2006 |   | /s/ MICHAEL  BARRETTI                                                      |   |
|                      |   | Michael Barretti                                                           |   |
|                      |   | Director                                                                   |   |
|                      |   |                                                                       |
| Dated: June 26,2006  |   | /s/ JERRY  DORSEY                                                          |   |
|                      |   | Jerry Dorsey                                                               |   |
|                      |   | Director                                                                   |   |
|                      |   |                                                                       |
| Dated: June 26, 2006 |   | /s/ WILLIAM  O’NEILL, JR.                                        |   |
|                      |   | William O’Neill, Jr.                                             |   |
|                      |   | Director                                                                   |   |
|                      |   |                                                                       |
| Dated: June 26, 2006 |   | /s/ ERIC G.  WALTERS                                                       |   |
|                      |   | Eric G. Walters                                                            |   |
|                      |   | Vice President and Chief Financial Officer  (Principal Accounting Officer) |   |

 

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