**SECURITIES AND EXCHANGECOMMISSION**

**WASHINGTON, D. C. 20459**

 

**FORM 10-Q/A**

 

**QUARTERLYREPORT UNDER SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**FOR THE QUARTER ENDED June 30, 2004**

 

**COMMISSION FILE NUMBER 0-20970**

 

**VISION-SCIENCES, INC.**

(Exact name of registrant as specified in itscharter)

 

| **Delaware**                                                                        | ** ** | **13-3430173**                        |
|-------------------------------------------------------------------------------------|------------|---------------------------------------|
| (State or other jurisdiction of  incorporation or organization)                     |       | (IRS Employer  Identification Number) |
|                                                                                |       |                                  |
| **9 Strathmore Road, Natick, MA**                                                   | ** ** | **01760**                             |
| (Address of principal executive offices)                                            |       | (Zip Code)                            |
|                                                                                |       |                                  |
| **(508) 650-9971**                                                                  |
| (Registrant’s telephone number, including  area code)                          |
|                                                                                |       |                                  |
| **None**                                                                            |
| (Former name, former address, and  former fiscal year if changed since last report) |

 

Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Actof 1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirement for the past 90 days.

 

Yes  ý        No  o

 

Indicate by check markwhether the registrant is an accelerated filer (as defined in Rule 12b-2 of theExchange Act).

 

Yes  o        No  ý

 

Indicate the number of shares outstanding of each of the issuer’sclasses of common stock, as of July 31, 2004.

 

| Common Stock, par value of $.01 |   | 30,919,713         |
|---------------------------------|--------|--------------------|
| (Title of Class)                |   | (Number of Shares) |

 

 

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Form 10-Q/A

 

We are filing this Form 10-Q/A forthe period ended June 30, 2004 for the following reason:

 

1.                                       Asof March 18, 2005 because we have made changes to Item 4, Controls and Procedures,and to the Certifications, Exhibits 31.1, 31.2 and 32.  In addition, we are updating the signaturepage as of March 18, 2005.

 

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**VISION-SCIENCES, INC.**

**TABLE OF CONTENTS**

 
| Part I.  | Financial Information |                                                                                        |
|----------|-----------------------|---------------------------------------------------------------------------------------------|
|     |                  |                                                                                        |
|     | Item 1.               | Financial Statements                                                                        |   |
|     |                  |                                                                                        |   |
|     |                  | Consolidated Balance Sheets                                                                 |   |
|     |                  |                                                                                        |   |
|     |                  | Consolidated Statements of Operations                                                       |   |
|     |                  |                                                                                        |   |
|     |                  | Consolidated Statement of Stockholders’  Equity                                        |   |
|     |                  |                                                                                        |   |
|     |                  | Consolidated Statements of Cash Flows                                                       |   |
|     |                  |                                                                                        |   |
|     |                  | Notes to Consolidated Financial Statements                                                  |   |
|     |                  |                                                                                        |   |
|     | Item 2.               | Management’s Discussion and Analysis of  Financial Condition and Results of Operations |   |
|     |                  |                                                                                        |   |
|     | Item 3.               | Quantitative and Qualitative Disclosures  about Market Risk                                 |   |
|     |                  |                                                                                        |   |
|     | Item 4.               | Controls and Procedures                                                                     |   |
|     |                  |                                                                                        |
| Part II. | Other Information     |                                                                                        |
|     |                  |                                                                                        |
|     | Item 5.               | Other Information                                                                           |   |
|     |                  |                                                                                        |   |
|     | Item 6.               | Exhibits and Reports on Form 8-K                                                            |   |
|     |                  |                                                                                        |
|     | Signatures            |                                                                                        |
|     |                  |                                                                                        |
|     | Exhibits              |                                                                                        |

 

2

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**PART I - FINANCIAL INFORMATION**

 

**Item 1:FINANCIAL STATEMENTS**

 

**VISION-SCIENCES, INC. AND SUBSIDIARIES**

**CONSOLIDATED BALANCE SHEETS**

**(Unaudited)**

 
| ** **                                                                                                                                                                              | ** ** | **June 30,  2004** | ** ** | **March 31,  2004** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|--------------------------|------------|
| ASSETS                                                                                                                                                                                  |       |                    |       |                     |       |
| Current Assets:                                                                                                                                                                         |       |                    |       |                     |       |
| Cash and cash equivalents                                                                                                                                                               |       | $                       | 2,530,584  |                     | $          | 2,714,941 |   |
| Accounts receivable, net of allowance for  doubtful accounts of $63,742 and $52,800, respectively                                                                                       |       | 1,416,965               |       | 1,683,459                |       |
| Inventories                                                                                                                                                                             |       | 1,641,701               |       | 1,352,716                |       |
| Prepaid expenses and deposits                                                                                                                                                           |       | 81,461                  |       | 62,182                   |       |
| Total current assets                                                                                                                                                                    |       | 5,670,711               |       | 5,813,298                |       |
|                                                                                                                                                                                    |       |                    |       |                     |       |
| Property and Equipment, at cost:                                                                                                                                                        |       |                    |       |                     |       |
| Machinery and equipment                                                                                                                                                                 |       | 3,762,060               |       | 3,623,854                |       |
| Furniture and fixtures                                                                                                                                                                  |       | 226,863                 |       | 212,002                  |       |
| Leasehold improvements                                                                                                                                                                  |       | 474,736                 |       | 473,411                  |       |
|                                                                                                                                                                                    |       | 4,463,659               |       | 4,309,267                |       |
| Less-Accumulated depreciation and  amortization                                                                                                                                         |       | 3,783,518               |       | 3,728,242                |       |
|                                                                                                                                                                                    |       | 680,141                 |       | 581,025                  |       |
|                                                                                                                                                                                    |       |                    |       |                     |       |
| Advance to Three BY Ltd.                                                                                                                                                                |       | 267,500                 |       | 267,500                  |       |
|                                                                                                                                                                                    |       |                    |       |                     |       |
| Other assets, net of accumulated  amortization of $49,014 and $47,428, respectively                                                                                                     |       | 65,165                  |       | 66,751                   |       |
| Total assets                                                                                                                                                                            |       | $                       | 6,683,517  |                     | $          | 6,728,574 |   |
|                                                                                                                                                                                    |       |                    |       |                     |       |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                               |       |                    |       |                     |       |
|                                                                                                                                                                                    |       |                    |       |                     |       |
| Current Liabilities:                                                                                                                                                                    |       |                    |       |                     |       |
| Acceptances payable to a bank                                                                                                                                                           |       | $                       | 70,247     |                     | $          | 51,766 |   |
| Current portion of note payable                                                                                                                                                         |       | 17,932                  |       | 17,495                   |       |
| Accounts payable                                                                                                                                                                        |       | 622,215                 |       | 681,998                  |       |
| Accrued expenses                                                                                                                                                                        |       | 955,159                 |       | 970,755                  |       |
| Total current liabilities                                                                                                                                                               |       | 1,665,553               |       | 1,722,014                |       |
|                                                                                                                                                                                    |       |                    |       |                     |       |
| Long term portion of note payable                                                                                                                                                       |       | 35,964                  |       | 40,614                   |       |
|                                                                                                                                                                                    |       |                    |       |                     |       |
| Stockholders’ Equity:                                                                                                                                                              |       |                    |       |                     |       |
| Common stock, $.01 par value—  Authorized—50,000,000 shares Issued and outstanding—30,899,213 shares at  June 30, 2004 and 30,687,963 shares at March 31, 2004 |       | 308,991                 |       | 306,879                  |       |
| Additional paid-in capital                                                                                                                                                              |       | 64,940,549              |       | 64,649,956               |       |
| Accumulated deficit                                                                                                                                                                     |       | (60,267,540             | )          | (59,990,889              | )          |
| Total stockholders’ equity                                                                                                                                                         |       | 4,982,000               |       | 4,965,946                |       |
| Total liabilities and stockholders’ equity                                                                                                                                         |       | $                       | 6,683,517  |                     | $          | 6,728,574 |   |

 

See accompanying notes to consolidatedfinancial statements.

 

3

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**VISION-SCIENCES, INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

**(Unaudited)**

 
| ** **                                                            | ** ** | **Three Months Ended  June 30,** | ** ** |
|-----------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                            | ** ** | **2004**                              | ** ** | **2003** | ** ** |
|                                                                  |       |                                  |       |   |   |
| Net sales                                                             |       | $                                     | 2,776,780  |   | $ | 1,960,482 |   |
| Cost of sales                                                         |       | 1,694,216                             |       | 1,202,897 |   |
|                                                                  |       |                                  |       |   |   |
| Gross profit                                                          |       | 1,082,564                             |       | 757,585 |   |
|                                                                  |       |                                  |       |   |   |
| Selling, general and administrative  expenses (1)                     |       | 996,435                               |       | 871,424 |   |
| Research and development expenses (1)                                 |       | 340,194                               |       | 159,639 |   |
| Stock-based compensation                                              |       | 33,526                                |       | 55,753 |   |
| Loss from operations                                                  |       | (287,591                              | )          | (329,231 | ) |
|                                                                  |       |                                  |       |   |   |
| Interest income                                                       |       | 8,685                                 |       | 8,172 |   |
| Interest expense                                                      |       | (1,403                                | )          | — |   |
| Other income, net                                                     |       | 3,658                                 |       | 3,611 |   |
|                                                                  |       |                                  |       |   |   |
| Net loss                                                              |       | $                                     | (276,651   | ) | $ | (317,448 | ) |
|                                                                  |       |                                  |       |   |   |
| Basic and diluted net loss per common share                           |       | $                                     | (0.01      | ) | $ | (0.01 | ) |
|                                                                  |       |                                  |       |   |   |
| Shares used in computing basic and diluted  net loss per common share |       | 30,835,192                            |       | 29,987,202 |   |

 

----

(1)          Excludesnon-cash stock-based compensation, as follows:

 
| Research and development expenses             |   | $      | 109    |   | $      | 37,393 |   |
|-----------------------------------------------|--------|--------|--------|--------|--------|--------|--------|
| Selling, general and administrative  expenses |   | 33,417 |   | 18,360 |   |
| Total                                         |   | $      | 33,526 |   | $      | 55,753 |   |

 

See accompanying notes to consolidatedfinancial statements.

 

4

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**VISION-SCIENCES, INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENT OF STOCKHOLDERS’EQUITY**

**(Unaudited)**

 
| ** **                                                                | ** ** | **Common Stock**    | ** ** | **Additional  Paid-in-Capital** | ** ** | **Accumulated  Deficit** | ** ** | **Total  Stockholders’  Equity** | ** ** | **Total  Comprehensive  Loss** | ** **  |
|---------------------------------------------------------------------------|------------|---------------------|------------|---------------------------------|------------|--------------------------|------------|---------------------------------------|------------|--------------------------------|-------------|
| **Number  of Shares**                                                     | ** ** | **$.01  Par Value** |
|                                                                      |       |                |       |                            |       |                     |       |                                  |       |                           |        |   |   |
| Balance, March 31, 2004                                              |       | 30,687,963          |       | $                               | 306,879    |                     | $          | 64,649,956                            |       | $                              | (59,990,889 | ) | $ | 4,965,946 |   |   |   |
| Exercise of stock options                                                 |       | 211,250             |       | 2,112                           |       | 257,067                  |       | —                                |       | 259,179                        |        |   |   |
| Compensation expense related to  non-employee non-qualified stock options |       |                |       |                            |       | 30,229                   |       | —                                |       | 30,229                         |        |   |   |
| Compensation expense related to employee  non-qualified stock options     |       |                |       |                            |       | 3,297                    |       |                                  |       | 3,297                          |        |   |   |
| Net loss                                                                  |       | —              |       | —                          |       | —                   |       | (276,651                              | )          | (276,651                       | )           | $ | (276,651 | ) |
|                                                                      |       |                |       |                            |       |                     |       |                                  |       |                           |        |   |   |
| Total comprehensive loss                                                  |       |                |       |                            |       |                     |       |                                  |       |                           |        | $ | (276,651 | ) |
|                                                                      |       |                |       |                            |       |                     |       |                                  |       |                           |        |   |   |
| Balance June 30, 2004                                                |       | 30,899,213          |       | $                               | 308,991    |                     | $          | 64,940,549                            |       | $                              | (60,267,540 | ) | $ | 4,982,000 |   |   |   |

 

See accompanying notes to consolidatedfinancial statements.

 

5

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**VISION-SCIENCES, INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Unaudited)**

 
| ** **                                                                                        | ** ** | **Three Months Ended  June 30, 2004** | ** ** | **Three Months Ended  June 30, 2003** | ** ** |
|---------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|--------------------------------------------|------------|
| Cash flows from operating activities:                                                             |       |                                       |       |                                       |       |
| Net loss                                                                                          |       | $                                          | (276,651   | )                                          | $          | (317,448 | ) |
| Adjustments to reconcile net loss to net  cash used for operating activities:                     |       |                                       |       |                                       |       |
| Depreciation and amortization                                                                     |       | 56,862                                     |       | 55,488                                     |       |
| Stock compensation for non-qualified  options                                                     |       | 33,526                                     |       | 55,753                                     |       |
| Changes in assets and liabilities:                                                                |       |                                       |       |                                       |       |
| Accounts receivable                                                                               |       | 266,494                                    |       | (245,983                                   | )          |
| Inventories                                                                                       |       | (288,985                                   | )          | 18,892                                     |       |
| Prepaid expenses and deposits                                                                     |       | (19,279                                    | )          | (718                                       | )          |
| Accounts payable                                                                                  |       | (59,783                                    | )          | 130,814                                    |       |
| Accrued expenses                                                                                  |       | (15,596                                    | )          | (3,718                                     | )          |
|                                                                                              |       |                                       |       |                                       |       |
| Net cash used for operating activities                                                            |       | (303,412                                   | )          | (306,920                                   | )          |
|                                                                                              |       |                                       |       |                                       |       |
| Cash flows used for investing activities                                                          |       |                                       |       |                                       |       |
| Increase in marketable securities                                                                 |       | —                                     |       | (312                                       | )          |
| Purchase of property and equipment, net                                                           |       | (154,392                                   | )          | (19,850                                    | )          |
| Advance to Three BY Ltd.                                                                          |       | —                                     |       | (69,978                                    | )          |
|                                                                                              |       |                                       |       |                                       |       |
| Net cash used for investing activities                                                            |       | (154,392                                   | )          | (90,140                                    | )          |
|                                                                                              |       |                                       |       |                                       |       |
| Cash flows provided by (used for) financing  activities:                                          |       |                                       |       |                                       |       |
| Payments on note payable for computer  equipment                                                  |       | (4,213                                     | )          | —                                     |       |
| Proceeds from acceptances payable to a bank                                                       |       | 18,481                                     |       | 6,848                                      |       |
| Proceeds from the sale of common stock, net                                                       |       | —                                     |       | 351,512                                    |       |
| Exercise of stock options                                                                         |       | 259,179                                    |       | —                                     |       |
| Net cash (used for) provided by financing  activities                                             |       | 273,447                                    |       | 358,360                                    |       |
|                                                                                              |       |                                       |       |                                       |       |
| Net (decrease) increase in cash and cash  equivalents                                             |       | (184,357                                   | )          | (38,700                                    | )          |
| Cash and cash equivalents, beginning of  period                                                   |       | 2,714,941                                  |       | 2,744,143                                  |       |
| Cash and cash equivalents, end of period                                                          |       | $                                          | 2,530,584  |                                       | $          | 2,705,443 |   |
|                                                                                              |       |                                       |       |                                       |       |
| Supplemental Disclosure of Cash Flow  Information:                                                |       |                                       |       |                                       |       |
| Cash paid during the period for interest                                                          |       | $                                          | 1,403      |                                       | $          | — |   |
|                                                                                              |       |                                       |       |                                       |       |
| Supplemental Disclosure of Non-cash Items  from Financing Activities:                             |       |                                       |       |                                       |       |
|                                                                                              |       |                                       |       |                                       |       |
| Fair market value of non-qualified options  granted in the period                                 |       | $                                          | 241,832    |                                       | $          | 1,411,550 |   |
|                                                                                              |       |                                       |       |                                       |       |
| Change in the fair market value of  non-qualified options existing at the beginning of the period |       | $                                          | —     |                                       | $          | 53,869 |   |

 

See accompanying notes to consolidatedfinancial statements.

 

6

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**VISION-SCIENCES, INC. AND SUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**(Unaudited)**

 

**1**.                                      **Basis of Presentation**

 

The consolidated financial statements included herein have beenprepared by the Company in accordance with accounting principles generallyaccepted in the United States of America, without audit, pursuant to the rulesand regulations of the Securities and Exchange Commission and include, in theopinion of management, all adjustments (consisting only of normal and recurringadjustments) that the Company considers necessary for a fair presentation ofsuch information.  Certain informationand footnote disclosures normally included in financial statements have beencondensed or omitted pursuant to such rules and regulations.  The Company believes, however, that itsdisclosures are adequate to make the information presented not misleading.  These consolidated financial statementsshould be read in conjunction with the audited consolidated financialstatements and notes thereto included in the Company’s latest annual report tostockholders.  The results for theinterim periods presented are not necessarily indicative of results to beexpected for the full fiscal year.

 

**2**.                                      **Summary of Significant Accounting Policies**

 

The accompanying consolidated financial statements reflect theapplication of certain accounting policies described below:

 

a.                                       *Principles of Consolidation*: The accompanying consolidatedfinancial statements include the accounts of the Company and its wholly-ownedsubsidiaries.  All material intercompanyaccounts and transactions have been eliminated in consolidation.

 

b**.****                                     ***Cash Equivalents*: Cash equivalents are carried at marketvalue, which approximates amortized cost*.** *Cash equivalents areshort-term, highly liquid investments with original maturities of less thanthree months.

 

c.                                       *Marketable Securities*: Marketable securities are carried atmarket value, which approximates amortized cost.  The Company has classified its investments inmarketable securities as available-for-sale securities.  At June 30, 2004, the Company had nomarketable securities.

 

d.                                      *Inventories*: Inventories are stated at the lower of cost or market using thefirst-in, first-out (FIFO) method and consist of the following:

 
| ** **      | ** ** | **June 30,  2004** | ** ** | **March 31,  2004** | ** ** |
|-----------------|------------|-------------------------|------------|--------------------------|------------|
| ** **      | ** ** | ** **              | ** ** | **(audited)**            | ** ** |
| ** **      | ** ** | ** **              | ** ** | ** **               | ** ** |
| Raw materials   |       | $                       | 1,060,223  |                     | $          | 726,221 |   |
| Work-in-process |       | 231,669                 |       | 297,220                  |       |
| Finished goods  |       | 349,809                 |       | 329,275                  |       |
|            |       | $                       | 1,641,701  |                     | $          | 1,352,716 |   |

 

Work-in-process and finished goods inventories consist of material,labor, and manufacturing overhead.

 

7

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e.                                       *Depreciation and Amortization*: The Company provides fordepreciation and amortization using the straight-line method in amounts thatallocate the cost of the assets to operations over their estimated useful livesas follows:

 
| **Asset Classification** | ** ** | **Estimated  Useful Life** | ** ** |
|--------------------------|------------|----------------------------|------------|
| Machinery and Equipment  |       | 3-5 Years                  |       |
| Furniture and Fixtures   |       | 5 Years                    |       |

 

Leasehold improvements are amortized over the shorter of their estimateduseful lives or the lives of the leases.

 

f.                                         *Basic and Diluted Net Loss Per Common Share*: Basic anddiluted net loss per common share is based on the weighted average number ofcommon shares outstanding.  Shares ofcommon stock issuable pursuant to outstanding stock options have not beenconsidered, as their effect would be antidilutive.

 

g.                                      *Revenue Recognition*: The following must occur before theCompany recognizes revenue: (1) persuasive evidence of an arrangement exists,(2) delivery has occurred or services have been rendered, (3) the price isfixed or determinable, (4) collectibility is reasonably assured and (5) thefair value of undelivered elements, if any, exists.  Generally, the Company does not enter intomultiple element arrangements.

 

h.                                      *Foreign Currency Transactions*: In accordance with Statementof Financial Accounting Standard (“SFAS”) No. 52, *ForeignCurrency Translation,* the Company charges foreign currency exchangegains or losses, in connection with its purchases of products from vendors inJapan, to operations, and charges foreign exchange translation gains and lossesto retained earnings.

 

i.                                          *Income Taxes*: The Company accounts for income taxes underthe liability method in accordance with SFAS No. 109, *Accountingfor Income Taxes*.  Under SFASNo. 109, deferred tax assets or liabilities are computed based upon thedifferences between the financial statement and income tax bases of assets andliabilities as measured by the enacted tax rates.

 

The Company has recorded a valuation allowance equal to its netdeferred tax asset due to the uncertainty of realizing the benefit of thisasset.

 

8

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j.                                          *Accounting for Derivative Instruments:*The Company accountsfor non-qualified stock option agreements issued to non-employees as equityinstruments, in accordance with the provisions of Emerging Issues Task Force(“EITF”) 96-18.  In the three monthsended June 30, 2004, the Company granted non-qualified options to purchase100,000 shares of the Company’s Common Stock to a consultant, with a value ofapproximately $241,832.  This value wasdetermined using the Black-Scholes option-pricing model.  The Company will recognize this amount in itsoperations ratably over a two-year period, according to the vestingschedule of the option.  In thethree months ended June 30, 2004, the Company recognized $30,229 ofexpense as stock-based compensation in the consolidated statement ofoperations.

 

k.                                       *Employee Stock-based Compensation Arrangements:*The Companyaccounts for its employee stock-based compensation arrangements using theintrinsic value method under the provisions of Accounting Principles BoardOpinion No. 25, *Accounting for Stock Issued to Employees*,and Financial Interpretation No. (“FIN”) 44. The Company does not recognize stock-based employee compensation costwhen the options granted have an exercise price equal to, or greater than, themarket value of the underlying common stock on the date of the grant.  The Company does recognize stock-basedemployee compensation cost when the options granted have an exercise price lessthan the market value of the underlying common stock on the date of the grant.

 

In June 2003, theCompany granted options to purchase 1,295,000 shares of common stock to itsemployees at an exercise price of $1.04 per share.  The fair market value of the common stock onthe date of grant was $1.09 per share. As a result, the Company has recognized compensation expense for thedifference between the fair market value and the option price over the life ofthe options.  In the three months endedJune 30, 2004, the Company recognized $3,297 of expense as stock-basedcompensation in the consolidated statement of operations.

 

9

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In accordance with theFinancial Accounting Standards Board (FASB) Statement No. 148, *Accounting for Stock-Based Compensation – Transition and Disclosure*,beginning in the quarter ending March 31, 2003, the Company adopted thedisclosure requirements of FASB No. 148. Had compensation expense for all stock option grants to employees beendetermined under the fair value method at the grant dates, consistent with themethod prescribed by SFAS No. 123, the Company’s net loss would have beenincreased to the pro forma amounts indicated as follows:

 
| ** **                                            | ** ** | **Three Months Ended June 30,** | ** ** |
|-------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                            | ** ** | **2004**                             | ** ** | **2003** | ** ** |
| Net loss – as reported                           |       | $                                    | (276,651   | ) | $ | (317,448 | ) |
| Stock-based employee compensation – as  reported |       | 3,297                                |       | 1,884 |   |
| Pro forma stock-based employee compensation           |       | (94,500                              | )          | (69,000 | ) |
| Net loss - pro forma                                  |       | $                                    | (367,854   | ) | $ | (384,564 | ) |
|                                                  |       |                                 |       |   |   |
| Net loss per share – as reported                 |       | $                                    | (.01       | ) | $ | (.01 | ) |
| Stock-based employee compensation – as  reported |       | —                               |       | — |   |
| Pro forma stock-based employee compensation           |       | —                               |       | — |   |
| Net loss per share - pro forma                        |       | $                                    | (.01       | ) | $ | (.01 | ) |

 

**3.****                                      ThreeBY Ltd.**

 

In June 2003, theCompany entered into a Contract Manufacturing Agreement, a Loan Agreement and aPledge Agreement (collectively, the “3BY Agreements”) with Three BY Ltd., anIsraeli company (“3BY”).  The 3BY Agreementsprovide for, among other things, the manufacture of certain of the Company’sproducts by 3BY, and a loan of up to $267,500 by the Company to 3BY for thepurchase and installation of certain manufacturing equipment by 3BY, at 3BY’sfacility, to be used to manufacture certain of the Company’s products.  As of December 31, 2003, the Company hadadvanced the complete loan.  3BY hascompleted the purchase and installation of the manufacturing equipment, and theCompany expects to begin receiving commercial production from 3BY in the threemonths ending September 30, 2004. The Company and 3BY plan to establish arepayment schedule, according to the 3BY Agreements.

 

10

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**4.****                                      SegmentInformation**

 

The Company has three reportablesegments – medical, industrial and corporate. The medical segment designs, manufactures and sells EndoSheaths andsells endoscopes to users in the health care industry.  The industrial segment designs, manufacturesand sells borescopes to a variety of users, primarily in the aircraft enginemanufacturing and aircraft engine maintenance industries.  In addition, the industrial segmentmanufactures and repairs endoscopes for the medical segment.  The corporate segment consists of certainadministrative expenses applicable to the Company as a whole and the managementoversight of the Company’s investment in Vision-Sciences Ltd. (the Company’sIsraeli subsidiary).

 

All segments follow the accounting policies described in the summary ofsignificant accounting policies.  TheCompany evaluates segment performance based upon operating income.  Identifiable assets are those used directlyin the operations of each segment. Corporate assets include cash, marketable securities and the assets ofVision-Sciences, Ltd.  Data regardingmanagement’s view of the Company’s segments are provided in the followingtables.

 
| **Three months ended  June 30,** | ** ** | **Medical** | ** ** | **Industrial** | ** ** | **Corporate** | ** ** | **Adjustments** | ** ** | **Total** | ** ** |
|---------------------------------------|------------|-------------|------------|----------------|------------|---------------|------------|-----------------|------------|-----------|------------|
| **2004**                              |       |        |       |           |       |          |       |            |       |      |       |
| Sales to external customers           |       | $           | 1,977,329  |           | $          | 799,451       |       | $               | —     |      | $          | — |   | $ | 2,776,780 |   |
| Intersegment sales                    |       | —      |       | 646,961        |       | —        |       | (646,961        | )          | —    |       |
| Operating income (loss)               |       | 10,072      |       | 20,232         |       | (317,895      | )          | —          |       | (287,591  | )          |
| Interest income (expense), net        |       | —      |       | —         |       | 7,282         |       | —          |       | 7,282     |       |
| Depreciation and amortization         |       | 44,383      |       | 10,973         |       | 1,506         |       | —          |       | 56,862    |       |
| Advance to 3BY Ltd.                   |       | —      |       | —         |       | —        |       | —          |       | —    |       |
| Other significant non-cash items:     |       |        |       |           |       |          |       |            |       |      |       |
| Stock-based compensation              |       | 187         |       | 63             |       | 33,276        |       | —          |       | 33,526    |       |
| Expenditures for fixed assets         |       | 149,733     |       | 4,659          |       | —        |       | —          |       | 154,392   |       |
| Total assets                          |       | 2,786,790   |       | 1,310,372      |       | 2,621,052     |       | (34,697         | )          | 6,683,517 |       |
|                                  |       |        |       |           |       |          |       |            |       |      |       |
| **2003**                              |       |        |       |           |       |          |       |            |       |      |       |
| Sales to external customers           |       | $           | 1,271,017  |           | $          | 689,465       |       | $               | —     |      | $          | — |   | $ | 1,960,482 |   |
| Intersegment sales                    |       | —      |       | 146,384        |       | —        |       | (146,384        | )          | —    |       |
| Operating income (loss)               |       | 23,823      |       | (24,529        | )          | (328,525      | )          | —          |       | (329,231  | )          |
| Interest income (expense)             |       | —      |       | —         |       | 8,172         |       | —          |       | 8,172     |       |
| Depreciation and amortization         |       | 45,532      |       | 9,956          |       | —        |       | —          |       | 55,488    |       |
| Advance to 3BY Ltd.                   |       | 69,978      |       | —         |       | —        |       | —          |       | 69,978    |       |
| Other significant non-cash items:     |       |        |       |           |       |          |       |            |       |      |       |
| Stock-based compensation              |       | 107         |       | 36             |       | 55,610        |       | —          |       | 55,753    |       |
| Expenditures for fixed assets         |       | 18,600      |       | 1,250          |       | —        |       | —          |       | 19,850    |       |
| Total assets                          |       | 2,108,176   |       | 951,540        |       | 2,922,801     |       | (311,910        | )          | 5,670,607 |       |

 

11

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## **Item 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

**Executive Summary**

 

This Quarterly Report onForm 10-Q contains forward-looking statements within the meaning of The PrivateSecurities Litigation Reform Act of 1995. Examples of forward-looking statements include statements aboutexpectations about future financial results, future products and future salesof new and existing products, future expenditures, and capital resources to meetanticipated requirements.  Withoutlimiting the foregoing, the words “believes”, “anticipates”, “plans”,“expects”, and similar expressions are intended to identify forward-lookingstatements.  These forward-lookingstatements involve risks and uncertainties, and our actual results may differsignificantly from those discussed in the forward-looking statements. Factorsthat might cause such a difference include, but are not limited to, theavailability of capital resources, the availability of third-partyreimbursement, government regulation, the availability of supplies,competition, technological difficulties, the continuation of our contract withMedtronic Xomed, Inc., general economic conditions and other risks detailed inour most recent Annual Report on Form 10-K and any subsequent periodic filingsmade with the Securities and Exchange Commission.  We do not undertake an obligation to updateour forward-looking statements to reflect future events or circumstances.

 

We develop, manufacture and sell flexible endoscope products for themedical device and industrial device markets. We operate in three reporting segments, medical, industrial andcorporate.

 

#### *Medical Segment*

#### * *

The medical segment supplies flexible endoscopes and disposableSlide-OnTM EndoSheath® Systems (“EndoSheaths”) to the Ear-Nose-Throat (“ENT”),gastrointestinal (“GI”), urology and pulmonary markets.  Health-care providers use EndoSheaths tocover the insertion tube of flexible endoscopes, such as ENT endoscopes,Trans-Nasal Esophagoscopes (“TNE”), sigmoidoscopes, cystoscopes andbronchoscopes.  We have designed theEndoSheaths to allow the health-care providers to process patients economicallyby permitting the providers to avoid reprocessing the endoscopes after eachuse.  In addition, the EndoSheaths ensurea sterile insertion tube for each patient procedure.

 

Our strategy in the medical segment is comprised of three components:a) improve sales distribution, b) lower manufacturing costs and c) increase thenumber of new product offerings.

 

#### *SalesDistribution*

#### * *

Since September 19, 2003 we have been distributing all of ourproducts for the ENT markets in the U.S.A. and Canada through Medtronic Xomed,Inc. (“Medtronic Xomed”) as part of our exclusive distribution agreement (the“Medtronic Agreement”) with them. The initial term of the Medtronic Agreementis three years.  Thereafter, theMedtronic Agreement will be automatically renewed for successive one-year periods,unless terminated by either party upon advance written notice.  Under the Medtronic Agreement, we havegranted Medtronic Xomed exclusive distribution rights in the United States andCanada to market and sell our ENT EndoSheaths and ENT endoscopes to ENTpractitioners.  As of July 2004Medtronic Xomed has completed the minimum purchase requirements for the initialtwelve-month period of the term, ending in August 2004 (“Year 1”).

 

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Under the Medtronic Agreement, in order to maintain its exclusivedistribution rights, Medtronic Xomed is required to purchase at least 110% ofthe Year 1 unit volume of ENT EndoSheaths in Year 2, at unit prices that wouldresult in total sales of those items to be approximately 90% of the Year 1total sales.  Due to higher than expectedinventory levels of ENT EndoSheaths at Medtronic Xomed, we have begundiscussions with Medtronic Xomed regarding quantities and prices for productsunder the Medtronic Agreement for delivery in September 2004 throughAugust 2005 (“Year 2”).  As a resultof the Medtronic Agreement, the success of our ENT product lines aresubstantially dependent upon the success of the marketing and sales activitiesof Medtronic Xomed over which we have limited control.  We have retained our domestic network ofindependent sales representatives for the GI, Urology and Pulmonary productlines.  Also, we have retained our owninternational network of distributors for all our medical product lines.

 

#### *CostReduction*

#### * *

In the fourth fiscal quarter of the year ended March 31, 2003 (“FY03”), we completed the installation of machinery used to manufacture ENTEndoSheaths in our Natick, Massachusetts facility.  We designed this machinery to lower the costto manufacture these items by increasing the automation of the assemblyprocess.  For the year endedMarch 31, 2004 (“FY 04”), the operation of the machinery resulted in areduction of the standard unit cost of ENT EndoSheaths of approximately43%.  During FY 04 we decided we couldreduce manufacturing costs further by sub-contracting the manufacture of ourEndoSheaths for the GI, Pulmonary and ENT markets to 3BY, Ltd., a company inIsrael.  We expect the first commercialshipments from 3BY in the three months ending September 30, 2004.

 

#### *NewProducts*

#### * *

In FY 04 we received clearance from the U.S. Food and DrugAdministration, (“FDA”) to market a number of new products to the ENTmarket.  In general, we designed theseproducts to allow the ENT physician to perform procedures in their offices, asopposed to the current practice of traveling to hospitals to use special ENTendoscopes to perform the procedures. Under the current reimbursement procedures of the Centers for Medicare& Medicaid Services (“CMS”), a governmental agency under the U.S.Department of Health and Human Services, the ENT physician will receive ahigher reimbursement by performing the procedures in their offices than theyreceive when they perform them in a hospital.

 

In April 2004 we received clearance to market our FlexibleCystoscope with Slide-On EndoSheath System, and plan to continue to introduceproducts during the twelve months ending March 31, 2005 (“FY 05”) thatenhance the practice efficiency of physicians and also protect patients.

 

#### *Industrial Segment*

#### * *

The industrial segment designs, manufactures and sells flexibleendoscopes, termed borescopes, for industrial users, and manufactures andrepairs flexible endoscopes for the medical segment.  The industrial segment users consistprimarily of companies in the aircraft engine manufacturing and maintenancemarkets and the defense market.

 

13

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#### *Corporate Segment*

#### * *

The corporate segment consists of certain administrative and businessdevelopment activities applicable to the company as a whole, and managementoversight of our investments in Vision Sciences, Ltd.

 

Critical AccountingPolicies and Estimates

 

This discussion and analysis of our financial condition and results ofoperations is based upon our Consolidated Financial Statements, which have beenprepared in accordance with accounting principles generally accepted in theUnited States.  See the Notes to theConsolidated Financial Statements included elsewhere herein.  Certain of our accounting policies requirethe application of judgment in selecting the appropriate assumptions forcalculating financial estimates.  Bytheir nature these judgments are subject to an inherent degree of uncertainty.  We periodically evaluate the judgments andestimates used for our critical accounting policies to ensure that suchjudgments and estimates are reasonable for our interim and year-end reportingrequirements.  These judgments andestimates are based upon our historical experience, current trends andinformation available from other sources, as appropriate.  If different conditions result from thoseassumptions used in our judgment, the results could be materially differentfrom our estimates.  Our criticalaccounting policies include the following:

 

### *RevenueRecognition*

### * *

We recognize revenue in accordance with SEC Staff Accounting BulletinNo. 104, *Revenue Recognition in Financial Statements*(SAB104), and EITF 00-21, *Revenue Arrangements withMultiple Deliverables*.  Thesepronouncements require that five basic criteria must be met before revenue canbe recognized: (1) persuasive evidence that an arrangement exists; (2) deliveryhas occurred or services rendered; (3) the fee is fixed and determinable; (4)collectibility is reasonably assured and (5) the fair value of undeliveredelements, if any, exists.  Determinationof criterion (4) is based on management’s judgment regarding the collectibilityof invoices for products and services delivered to customers.  Should changes in conditions cause managementto determine these criteria are not met for certain future transactions,revenue recognized for any reporting period could be adversely affected.

 

# ***Non-qualified Options Issued toNon-employees***

# ** **

Effective March 31, 2004, we account for non-qualified optionsissued to non-employees as equity instruments, in accordance with theprovisions of EITF 96-18.  Fair valuesfor these non-qualified options are derived from pricing models that considercurrent market and contractual prices for the underlying financial instruments,as well as time value, yield curve and volatility factors underlying thepositions.  Pricing models and theirunderlying assumptions impact the amount and timing of the value of thesenon-qualified options, and the use of different pricing models or assumptions couldproduce different financial results.  Weuse the Black-Scholes option-pricing model for determining the value ofnon-qualified options issued to non-employees, and we expense that value overthe vesting period of the non-qualified options.

 

14

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We account for certain non-qualified options granted to employees topurchase our common stock in accordance with SFAS No. 123, *Accountingfor**Stock-Based Compensation.*  If the fair market value of the underlyingstock at the date of grant is greater than the option price, we recognizecompensation expense for the difference between the market price and the optionprice over the vesting period of the options.

 

**Results of Operations**

 

Sales

 

Net sales for the three monthsended June 30, 2004 (“Q1 05”) were $2,776,780, an increase of $816,298, or42%, compared to the three-month period ended June 30, 2003 (“Q104”).  During Q1 05, sales of the medicalsegment increased by $706,312, or 56%, to $1,977,329, and sales of the industrialsegment increased by $109,986, or 16%, to $799,451, compared to Q1 04.  In the medical segment, the sales and changesin sales by market were as follows ($000’s):

 
| **Market** | ** ** | **Q1 05** | ** ** | **Q1 04** | ** ** | **Increase  (Decrease)** | ** ** | **Percent** | ** ** |
|------------|------------|-----------|------------|-----------|------------|--------------------------|------------|-------------|------------|
| ENT        |       | $         | 1,732      |      | $          | 1,058                    |       | $           | 674        |   | 64 | % |
| GI         |       | 93        |       | 151       |       | (58                      | )          | (38         | )%         |
| Urology    |       | 23        |       | —    |       | 23                       |       | 100         | %          |
| Pulmonary  |       | 7         |       | 15        |       | (8                       | )          | (53         | )%         |
| Other      |       | 122       |       | 47        |       | 75                       |       | 160         | %          |
| Total      |       | $         | 1,977      |      | $          | 1,271                    |       | $           | 706        |   | 56 | % |

 

*Medical Sales – ENT Market*

 

Sales to the ENT market include products for domestic and internationalcustomers as follows:

 
| **ENT Market** | ** ** | **Sales Q1 05** | ** ** | **Sales Q1 04** | ** ** | **Increase  (Decrease)** | ** ** | **Percent** | ** ** |
|----------------|------------|-----------------|------------|-----------------|------------|--------------------------|------------|-------------|------------|
| Domestic       |       | $               | 1,110      |            | $          | 467                      |       | $           | 643        |   | 138 | % |
| International  |       | 622             |       | 591             |       | 31                       |       | 5           | %          |
| Total ENT      |       | $               | 1,732      |            | $          | 1,058                    |       | $           | 674        |   | 64 | % |

 

We further delineate products sold to the domestic market as follows:

 
| **ENT Products**     | ** ** | **Sales Q1 05** | ** ** | **Sales Q1 04** | ** ** | **Increase  (Decrease)** | ** ** | **Percent** | ** ** |
|----------------------|------------|-----------------|------------|-----------------|------------|--------------------------|------------|-------------|------------|
| Slide-On EndoSheaths |       | $               | 683        |            | $          | 399                      |       | $           | 284        |   | 71 | % |
| Endoscopes           |       | 336             |       | 67              |       | 269                      |       | 401         | %          |
| Other products       |       | 91              |       | 1               |       | 90                       |       | 100         | %          |
| Total Domestic       |       | $               | 1,110      |            | $          | 467                      |       | $           | 643        |   | 138 | % |

 

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The primary reasons for the increase in sales of ENT products to thedomestic market were the continued purchases of ENT Slide-On EndoSheaths andENT endoscopes by Medtronic Xomed, according to the agreement we signed withthem in August 2003.  The portion ofthe sales increase due to the products specifically contained in the MedtronicAgreement was approximately $433,000.  Inaddition, the remaining sales increase of approximately $210,000 was due tosales of new products to Medtronic Xomed that were not available for sale in Q104, including our ENT-1000 small diameter endoscope, EndoSheaths for theENT-1000 and products related to the diagnosis of swallowing problems inpatients.

 

As of July 2004, Medtronic Xomed has completed the minimumpurchase requirements for Year 1.  Underthe Medtronic Agreement, in order to maintain its exclusive distributionrights, Medtronic Xomed is required to purchase at least 110% of the Year 1unit volume of ENT EndoSheaths in Year 2, at unit prices that would result intotal sales of those items to be approximately 90% of the Year 1 totalsales.  Due to higher than expectedinventory levels of ENT EndoSheaths at Medtronic Xomed, we have begundiscussions with them regarding quantities and prices for products under theMedtronic Agreement for delivery in Year 2. We expect to negotiate quantities and prices that will be beneficial toboth our company and Medtronic Xomed. There can be no assurance, however, that the level of domestic sales ofENT EndoSheaths will be maintained in Year 2 by Medtronic Xomed. We havereleased other ENT products in Year 1 that were not included in the agreement,such as the endoscopes and EndoSheaths for the ENT-1000 and Trans-NasalEsophagoscope (“TNE D”), and we expect unit and dollar sales of these productswill be higher in Year 2 than in Year 1. We also expect to release new products, including our TNE Bx (formerlyknown as TNE T, but changed to reflect the biopsy capability inherent in itsdesign), or therapeutic flexible endoscope and Slide-On EndoSheath System.  As a result of the Medtronic Agreement, thesuccess of our ENT product lines will continue to be substantially dependentupon the success of the marketing and sales activities of Medtronic Xomed, overwhich we have limited control.

 

Unit sales of ENT EndoSheaths in Q1 05 were 93,520, an increase of153%, compared to unit sales in Q1 04. Unit sales of ENT endoscopes were 97, an increase of 81, or 506%,compared to Q1 04.  Included in the unitsales of ENT EndoSheaths and ENT endoscopes in Q1 05 were 800 EndoSheaths forthe ENT-1000 and 31 ENT-1000 endoscopes, products not available for sale in Q104.

 

We further delineate products sold to the international market asfollows:

 
| **ENT Products**     | ** ** | **Sales Q1 05** | ** ** | **Sales Q1 04** | ** ** | **Increase (Decrease)** | ** ** | **Percent** | ** ** |
|----------------------|------------|-----------------|------------|-----------------|------------|-------------------------|------------|-------------|------------|
| Slide-On EndoSheaths |       | $               | 518        |            | $          | 482                     |       | $           | 36         |   | 7 | % |
| Endoscopes           |       | 100             |       | 106             |       | (6                      | )          | (6          | )%         |
| Other products       |       | 4               |       | 3               |       | 1                       |       | 33          | %          |
| Total International  |       | $               | 622        |            | $          | 591                     |       | $           | 31         |   | 5 | % |

 

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The increase in sales to international distributors is primarily due tohigher prices for ENT EndoSheaths established as of April 1, 2004.  At that time we increased prices approximately8% for ENT EndoSheaths and 5% for ENT endoscopes.  Unit sales of ENT EndoSheaths to theinternational distributors were 82,800 in Q1 05, a slight decrease compared to82,820 units sold in Q1 04.  Included inthe units sold in Q1 05 were 160 units for the ENT-1000 endoscope, notavailable for sale in Q1 04.  Demandcontinued strong from our distributor in the U.K., but lagged from ourdistributors in the European Union and Australia.  Some of this slower demand was due topurchases made in our fourth fiscal quarter of FY 04 to avoid the planned priceincrease.  We do not expect the priceincrease to have a continuing negative effect on unit sales for the remainderof FY 05, but there can be no assurance that we will be able to maintain thoseprice increases.

 

Unit sales of ENT endoscopes in Q1 05 to international distributorswere 27, compared to 31 in Q1 04.  Unitsales in Q1 05 included 7 units of the ENT-1000, not available for sale in Q104.  Sales of ENT endoscopes aredependent upon a variety of factors, including the timing requirements of endusers, foreign exchange rates, sales promotions of international competitorsand other factors.  We believe the lowerdemand in Q1 05 was partially due to the planned price increase announcedduring FY 04 and effective on April 1, 2004.  During FY 05 we plan to increase ourmarketing efforts by attending more trade shows and hosting symposiums forphysicians where they can experience the benefits that our products can have onthe efficiency of their practices and the protection our products offerpatients.  In addition, we plan tocontinue to sign agreements with distributors in countries where we do not havea presence.  However, there can be noassurance we will be able to consummate these agreements on terms that arebeneficial to us.

 

*Medical Sales – Other Markets*

 

Sales to the GI market declined in Q1 05, compared to Q1 04, dueprimarily to lower demand for our proprietary sigmoidoscope EndoSheaths due tothe continued insufficiency of reimbursement rates to physicians to support theuse of the products.  We expect thisdecline to continue during FY 05.

 

During Q1 05 we launched our new Flexible Cystoscope (“CST-2000”) withSlide-On EndoSheath System at the American Urological Association tradeshow.  Late in Q1 05, we CE-marked theproduct for sale to international distributors, and shipped the first units ofour CST-2000 endoscope and EndoSheaths to an international distributor.  We believe the CST-2000 and EndoSheath Systemcan significantly enhance the practice efficiency of urologists by allowingthem to avoid the tedious reprocessing of conventional cystoscopes.  In addition, the use of our CST-2000 withSlide-On EndoSheath System avoids the need to reprocess endoscopes with harshchemicals, one of which has been contraindicated for use on patients withbladder cancer.

 

*Industrial Segment*

 

The increase in sales of the industrial segment was due to higherdemand for repairs of borescopes, offset partially by lower demand for newborescopes.

 

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Gross Profit

 

Gross profit was $1,082,564 in Q1 05, an increase of $324,979, comparedto gross profit in Q1 04.  Gross profitincreased by approximately $268,700 in the medical segment, and increased byapproximately $56,300 in the industrial segment.  The increase in gross profit in the medicalsegment was due primarily to the higher unit volume of the ENT endoscopes andSlide-On EndoSheaths, offset partially by lower prices due to the MedtronicXomed agreement.  In the industrialsegment, the increase in gross profit was due primarily to a more profitablemix of products and services.

 

In FY 04, we began the process of moving the manufacturing of ourEndoSheaths to 3BY Ltd, a sub-contractor in Israel, to further reduce themanufacturing cost of these products.  Weadvanced $267,500 to the sub-contractor for the purchase and installation ofmachinery to produce ENT EndoSheaths.  Weexpect to receive the first commercial shipments of these products in the threemonths ending September 30, 2004. The transfer of the manufacturing of the GI and pulmonary products andthe installation of the line of ENT manufacturing equipment took longer than wehad expected.

 

Operating Expenses

 

*Selling, General and Administrative Expenses*

 

The increase in selling, general and administrative (“SG&A”)expenses in Q1 05 was due primarily to higher costs incurred in the medicalsegment, totaling approximately $131,000, for marketing and promotion relatedto trade shows where we introduced new products to the urology and GI markets.

 

*Research and Development Expenses*

 

The increase in R&Dexpenses in Q1 05, compared to Q1 04 was due primarily to additional spendingfor materials and personnel hired to work on developing new products for the medicalsegment.  We expect costs for R&Dwill continue to be higher in FY 05, compared to FY 04, as we increase ourefforts to develop new products utilizing the technology inherent in ourEndoSheaths.  In addition, we began todevelop a series of peripheral products for our markets, including an imagemanagement and archival system that we expect to begin selling in the secondhalf of FY 05.

 

On May 29, 2003 we signeda Development, Supply and Distribution Agreement (“DSDA”) with EndoscopicTechnologies, Inc. (“ESTECH”), a company with certain proprietary technologiesrelating to methods for minimally-invasive cardiovascular surgery.  In the DSDA, we and ESTECH have agreed to usecommercially reasonable and diligent efforts to complete the development of certainproducts being designed for minimally-invasive surgery, specifically for thetreatment of atrial fibrillation.  Thetotal value of the product development component of the DSDA is approximately$90,000.  According to the terms of theDSDA, as of June 30, 2003, we had invoiced $45,000 to ESTECH, and recordedthat total amount in a deferred revenue account within accruedliabilities.  We have utilizedpercentage-completion accounting to recognize revenue from this contract.  During Q1 05, we have estimated that we are50% complete with this contract, and have accordingly recognized $45,000 insales in Q1 05.

 

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We expect to continue towork with ESTECH to complete this project. However, due to the inherent difficulties in estimating the timing ofstages of completion of project such as this, there can be no assurance that wewill complete the development of this project in FY 05.

 

*Stock-basedCompensation Expenses*

 

We incurred stock-basedcompensation costs during Q1 05, due primarily to the grant in April 2004of a non-qualified option to purchase 100,000 shares of our Common Stock to anoutside consultant.  This grant was inaccordance with an agreement entered into with the consultant inJanuary 2003.  The value of thenon-qualified option was determined to be approximately $242,000, using theBlack-Scholes option-pricing model, and will be recorded in our statements ofoperations over the vesting period of the option.  During Q1 05, we recorded approximately$30,000 related to this non-qualified option. In addition, during the three months ended June 30, 2003, thecompensation committee of our board of directors authorized the issuance ofnon-qualified options to purchase 1,295,000 shares of common stock to certainof our employees.  These options werepriced below the fair market price of our common stock on the date ofgrant.  Accordingly, we will recognizecompensation expense totaling approximately $65,000 from June 2003 throughDecember 2007, the vesting period of these options.  In Q1 05, we incurred approximately $3,000 ofexpense for these options in our statement of operations.

 

Operating Income (Loss)

 

Operating income (loss)by segment was as follows ($000’s):

 
| **Segment** | ** ** | **Q1 05** | ** ** | **Q1 04** | ** ** | **Change** | ** ** |
|-------------|------------|-----------|------------|-----------|------------|------------|------------|
| Medical     |       | $         | 10         |      | $          | 24         |       | $ | (14 | ) |
| Industrial  |       | 20        |       | (25       | )          | 45         |       |
| Corporate   |       | (318      | )          | (328      | )          | 10         |       |
| Total       |       | $         | (288       | )         | $          | (329       | )          | $ | 41 |   |

 

In the medical segment, expenses in S,G&A and R&D increasedmore than gross profit increased, resulting in a lower operating income for Q105, compared to Q1 04.  In the industrialsegment, the higher gross profit more than offset the higher S,G&Aexpenses, resulting in an operating profit in Q1 05, compared to a loss in Q104.  In the corporate segment, lowercosts for stock-based compensation for non-qualified options to non-employeeswas the primary driver for the lower loss.

 

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Liquidity and Capital Resources

 

At June 30, 2004, our principal source ofliquidity was working capital of approximately $4.0 million, including$2.5 million in cash and cash equivalents. At June 30, 2004, we had acceptances payable to a bank totalingapproximately $70,000.  We have pledged$125,000 to secure the acceptances payable.

 

We also have an agreement with a bank, which includesa revolving line of credit under which we may borrow up to $1,000,000, net ofup to $250,000 of any outstanding letters of credit and banker’sacceptances.  Borrowings under this loan arrangementmust be fully cash collateralized.  Theagreement also stipulates that when we achieve positive cash flow, as definedin the agreement, we will be eligible to negotiate changes to this loanarrangement that may include changing the borrowing base for revolving loans,and the release of the pledged cash collateral.

 

Our cash and cashequivalents decreased by approximately $184,000 in the three months endedJune 30, 2004, due primarily to cash used for operations of approximately$303,000 and cash used for investing activities of approximately $154,000.  These uses were offset by the exercise ofstock options by employees and non-employees, resulting in approximately$259,000 of cash generated.  We expectour current balance of cash and cash equivalents is sufficient to fund ouroperations at least for the next twelve months.

 

In connection with the 3BY Agreements, we expect to establish arepayment schedule for the advance of $267,500 for the purchase ofequipment to manufacture our ENT EndoSheaths in Israel, during the three monthsending September 30, 2004 when we expect the production line to be fullyoperational.  3BY has agreed to provideus a security interest in the equipment to be purchased, or in other equipmentof equal value.

 

We expect total spending for property and equipment to be approximately$700,000 for FY 05.

 

We conduct our operations in certain facilities leased from non-relatedparties.  These leases expire on variousdates through October 31, 2006.  Inaddition, we have operating leases for certain office equipment leased fromnon-related parties.  These leases expireon various dates through May 2006.  Thefollowing chart summarizes our contractual obligations as of March 31,2004.

 
| **Contractual Obligation** | ** ** | **Total** | ** ** | **Due within 1 year** | ** ** | **Due in 1-3 years** | ** ** |
|----------------------------|------------|-----------|------------|-----------------------|------------|----------------------|------------|
| Operating leases           |       | $         | 701,347    |                  | $          | 331,723              |       | $ | 369,624 |   |
|                            |            |           |            |                       |            |                      |            |  |  |  |

 

We have no off-balance sheet arrangements that have, or are reasonablylikely to have, a current or future effect on our financial condition, changesin financial condition, revenues or expenses, results of operations, liquidity,capital expenditures or capital resources.

 

We have incurred losses since our inception, and losses are expected tocontinue at least during FY 05.  We havefunded the losses principally with the proceeds from public and private equityfinancings.  Although we do notanticipate the need for additional financing in FY 05, management has decidedthat new financing may be desirable. However, there can be no assurance that additional funding will beavailable, or available on reasonable terms.

 

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## **Item 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK**

## ** **

In the normal course of business, we are subject to the risksassociated with fluctuations in interest rates and changes in foreign currencyexchange rates.

 

#### *Interest andMarket Risk*

#### * *

We currently invest ourexcess cash in a money market account at our bank.  We have not used derivative financialinstruments in our investment portfolio. We attempt to limit our exposure to interest rate and credit risk byplacing our investments with high-quality financial institutions and haveestablished investment guidelines relative to diversification and maturitiesdesigned to maintain safety and liquidity.

 

Investments in both fixed-rate and floating-rate interest earninginstruments carry a degree of interest rate risk.  Fixed-rate securities may have their fairmarket value adversely impacted due to a rise in interest rates, whilefloating-rate securities may produce less income than expected if interestrates decline.  Due in part to thesefactors, our future investment income may fall short of expectations due tochanges in interest rates, or we may suffer losses in principal if forced tosell securities which have seen a decline in market value due to changes ininterest rates.

 

#### *Foreign CurrencyExchange*

#### * *

We face exposure, due to purchases of raw materials from Japanesesuppliers, to adverse movements in the value of the Japanese Yen.  This exposure may change over time, and couldhave a materially adverse effect on our financial results.  We may attempt to limit this exposure bypurchasing forward contracts, as required. Most of our liabilities are settled within 90 days of receipt ofmaterials.  At June 30, 2004, ourliabilities relating to Japanese Yen were approximately $177,000.

 

## **Item 4.  CONTROLS AND PROCEDURES**

 

*a)**            Evaluation ofDisclosure Controls and Procedures.*

 

Based on an evaluation of our disclosure controls and procedures (asdefined in Rules 13a-14(c) and 15d-14(c) under the Securities Exchange Act of1934), the chief executive officer and chief financial officer have concludedthat our disclosure controls and procedures as of the end of the three monthsended June 30, 2004, are effective. 

 

*b)**            Changes in InternalControls.*

 

There were no changes in ourinternal controls over financial reporting that occurred during the fiscalquarter ended June 30, 2004 that have materially affected, or are reasonablylikely to materially affect, our internal controls over financial reporting. 

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**PART II - OTHER INFORMATION**

 

**Item5.  Other Information**

 

**Item6.  Exhibits and Reports on Form 8-K**

 

(a)                                  Exhibits

 
| 31.1   |   | Certification of Chief Executive Officer pursuant to Rule  13a-14(a)/15d-14(a), promulgated under the Securities Exchange Act of 1934,  as amended.                                 |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                |
| 31.2   |   | Certification of Chief Financial Officer pursuant to Rule  13a-14(a)/15d-14(a), promulgated under the Securities Exchange Act of 1934,  as amended.                                 |
|   |   |                                                                                                                                                                                |
| 32     |   | Certification of Chief Executive Officer and Chief Financial Officer  pursuant to 18 U.S.C. §1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |

 

(b)                                 Reports on Form 8-K

 

None.

 

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##### **SIGNATURES**

 

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

 

VISION-SCIENCES, INC.

 

 
| Date: March 18, 2005 |   | /s/ Ron Hadani                                                                                                                 |   |
|---------------------------|--------|--------------------------------------------------------------------------------------------------------------------------------|--------|
|                      |   | Ron Hadani                                                                                                                     |
|                      |   | President, CEO (Duly Authorized Officer)                                                                                       |
|                      |   |                                                                                                                           |
|                      |   |                                                                                                                           |
| Date: March 18, 2005 |   | /s/ James A. Tracy                                                                                                             |   |
|                      |   | James A. Tracy                                                                                                                 |
|                      |   | Vice President Finance, Chief Financial Officer and  Controller (Principal Financial Officer and Principal Accounting Officer) |
|                           |        |                                                                                                                                |        |  |

 

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