**SECURITIES AND EXCHANGECOMMISSION**

**WASHINGTON, D. C. 20459**

 

**FORM 10-Q**

 

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

 

**FOR THE QUARTER ENDED December 31, 2005**

 

**COMMISSION FILE NUMBER 0-20970**

 

**VISION-SCIENCES, INC.**

(Exact name of registrant as specified in its charter)

 
| **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, andformer fiscal year if changed since last report)

 

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirement for the past 90 days.

Yes  ý          No  o

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of"accelerated filer and large accelerated filer'' in Rule 12b-2 or theExchange Act. (Check one):

 

| Large  accelerated filer  o |   | Accelerated filer  o |   | Non-accelerated filer  ý |
|---------------------------------------|--------|--------------------------------|--------|-----------------------------------------|

 

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

Yes  o          No  ý

 

Indicatethe number of shares outstanding of each of the issuer’s classes of commonstock, as of January 31, 2006.

 

| **Common Stock, par value of $ .01** | ** ** | **35,139,877**     | ** ** |
|-------------------------------------------|------------|--------------------|------------|
| (Title of Class)                          |       | (Number of Shares) |       |

 

 

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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 and Comprehensive Loss                         |   |
|          | 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. List of Exhibits                                                                           |   |
|          |                                                                                                |   |
|          | Signatures                                                                                          |   |
|          |                                                                                                |   |
|          | Exhibits                                                                                            |   |

 

2

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**PART I - FINANCIALINFORMATION**

 

**Item 1: FINANCIAL STATEMENTS**

 

**VISION-SCIENCES, INC. AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETS**

**(Unaudited)**

 
| ** **                                                                                                                                                                                 | ** ** | **December 31,  2005** | ** ** | **March 31,  2005** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|--------------------------|------------|
| ASSETS                                                                                                                                                                                     |       |                        |       |                     |       |
| Current Assets:                                                                                                                                                                            |       |                        |       |                     |       |
| Cash and cash equivalents                                                                                                                                                                  |       | $                           | 6,933,158  |                     | $          | 9,868,586 |   |
| Accounts receivable, net of allowance for doubtful  accounts of $139,209 and $70,097, respectively                                                                                         |       | 1,963,245                   |       | 1,662,486                |       |
| Inventories                                                                                                                                                                                |       | 2,269,169                   |       | 1,876,824                |       |
| Prepaid expenses and deposits                                                                                                                                                              |       | 73,447                      |       | 61,964                   |       |
| Total current assets                                                                                                                                                                       |       | 11,239,019                  |       | 13,469,860               |       |
|                                                                                                                                                                                       |       |                        |       |                     |       |
| Property and Equipment, at cost:                                                                                                                                                           |       |                        |       |                     |       |
| Machinery and equipment                                                                                                                                                                    |       | 4,732,661                   |       | 4,427,047                |       |
| Furniture and fixtures                                                                                                                                                                     |       | 249,652                     |       | 242,406                  |       |
| Leasehold improvements                                                                                                                                                                     |       | 579,032                     |       | 573,780                  |       |
|                                                                                                                                                                                       |       | 5,561,345                   |       | 5,243,233                |       |
| Less-Accumulated depreciation and amortization                                                                                                                                             |       | 4,363,833                   |       | 4,040,060                |       |
|                                                                                                                                                                                       |       | 1,197,512                   |       | 1,203,173                |       |
|                                                                                                                                                                                       |       |                        |       |                     |       |
| Other assets, net of accumulated amortization of  $58,541 and $53,815, respectively                                                                                                        |       | 70,091                      |       | 74,816                   |       |
| Total assets                                                                                                                                                                               |       | $                           | 12,506,622 |                     | $          | 14,747,849 |   |
|                                                                                                                                                                                       |       |                        |       |                     |       |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                                                                  |       |                        |       |                     |       |
| Current Liabilities:                                                                                                                                                                       |       |                        |       |                     |       |
| Acceptances payable to a bank                                                                                                                                                              |       | $                           | 24,266     |                     | $          | — |   |
| Current portion of note payable                                                                                                                                                            |       | 25,912                      |       | 24,431                   |       |
| Accounts payable                                                                                                                                                                           |       | 849,530                     |       | 637,408                  |       |
| Accrued expenses                                                                                                                                                                           |       | 1,076,718                   |       | 1,213,577                |       |
| Total current liabilities                                                                                                                                                                  |       | 1,976,426                   |       | 1,875,416                |       |
|                                                                                                                                                                                       |       |                        |       |                     |       |
| Long-term portion of note payable                                                                                                                                                          |       | 11,115                      |       | 31,089                   |       |
|                                                                                                                                                                                       |       |                        |       |                     |       |
| Stockholders’ Equity:                                                                                                                                                                 |       |                        |       |                     |       |
| Common stock, $.01 par value—Authorized—50,000,000  shares Issued and outstanding—35,133,597 shares at December 31, 2005 and  34,998,877 shares at March 31, 2005 |       | 351,335                     |       | 349,988                  |       |
| Additional paid-in capital                                                                                                                                                                 |       | 75,575,951                  |       | 74,987,548               |       |
| Accumulated deficit                                                                                                                                                                        |       | (65,408,205                 | )          | (62,496,192              | )          |
| Total stockholders’ equity                                                                                                                                                            |       | 10,519,081                  |       | 12,841,344               |       |
| Total liabilities and stockholders’ equity                                                                                                                                            |       | $                           | 12,506,622 |                     | $          | 14,747,849 |   |

 

See accompanying notes to consolidated financial statements.

 

3

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**VISION-SCIENCES, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTSOF OPERATIONS**

**(Unaudited)**

 
| ** **                                                            | ** ** | **Three Months Ended  December 31,** | ** ** | **Nine Months Ended  December 31,** | ** ** |
|-----------------------------------------------------------------------|------------|-------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                            | ** ** | **2005**                                  | ** ** | **2004**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                            | ** ** | ** **                                | ** ** | ** **                               | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net sales                                                             |       | $                                         | 3,330,041  |                                     | $          | 2,826,949 |   | $ | 8,164,551 |   | $ | 7,635,167 |   |
| Cost of sales                                                         |       | 2,445,318                                 |       | 2,040,079                                |       | 6,175,340 |   | 5,514,894 |   |
|                                                                  |       |                                      |       |                                     |       |   |   |   |   |
| Gross profit                                                          |       | 884,723                                   |       | 786,870                                  |       | 1,989,211 |   | 2,120,273 |   |
|                                                                  |       |                                      |       |                                     |       |   |   |   |   |
| Selling, general and administrative expenses (1)                      |       | 1,059,153                                 |       | 1,103,583                                |       | 3,124,338 |   | 2,944,640 |   |
| Research and development expenses (1)                                 |       | 593,308                                   |       | 412,111                                  |       | 1,532,748 |   | 1,060,854 |   |
| Stock-based compensation                                              |       | 288,947                                   |       | 65,843                                   |       | 388,316 |   | 132,895 |   |
| Loss from operations                                                  |       | (1,056,685                                | )          | (794,667                                 | )          | (3,056,191 | ) | (2,018,116 | ) |
|                                                                  |       |                                      |       |                                     |       |   |   |   |   |
| Interest income                                                       |       | 56,237                                    |       | 3,862                                    |       | 143,117 |   | 19,936 |   |
| Interest expense                                                      |       | (731                                      | )          | (1,190                                   | )          | (2,549 | ) | (3,891 | ) |
| Other income, net                                                     |       | (1,190                                    | )          | 5,773                                    |       | 3,610 |   | 9,432 |   |
|                                                                  |       |                                      |       |                                     |       |   |   |   |   |
| Net loss                                                              |       | $                                         | (1,002,369 | )                                        | $          | (786,222 | ) | $ | (2,912,013 | ) | $ | (1,992,639 | ) |
|                                                                  |       |                                      |       |                                     |       |   |   |   |   |
| Basic and diluted net loss per common share                           |       | $                                         | (0.03      | )                                        | $          | (0.03 | ) | $ | (0.08 | ) | $ | (0.06 | ) |
|                                                                  |       |                                      |       |                                     |       |   |   |   |   |
| Shares used in computing basic and diluted net loss  per common share |       | 35,128,478                                |       | 30,976,505                               |       | 35,089,761 |   | 30,912,528 |   |

 

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

 
| Research and development expenses            |   | $       | 4,622   |   | $      | 109     |   | $       | 4,841   |   | $ | 328     |   |
|----------------------------------------------|--------|---------|---------|--------|--------|---------|--------|---------|---------|--------|---|---------|--------|
| Selling, general and administrative expenses |   | 284,325 |    | 65,734 |   | 383,475 |   | 132,567 |    |
| Total                                        |   | $       | 288,947 |   | $      | 65,843  |   | $       | 388,316 |   | $ | 132,895 |   |

 

See accompanying notes to consolidated financial statements.

 

4

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**VISION-SCIENCES, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTOF STOCKHOLDERS’ EQUITYand COMPREHENSIVE LOSS(Unaudited)**

 
| ** **                                                                  | ** ** | **Common Stock**      | ** ** | ** **          | ** ** | ** **                      | ** ** | **Total**                | ** ** | **Total**                      | ** **  |
|-----------------------------------------------------------------------------|------------|-----------------------|------------|---------------------|------------|---------------------------------|------------|--------------------------|------------|--------------------------------|-------------|
| ** **                                                                  | ** ** | **Number  of Shares** | ** ** | **$.01  Par Value** | ** ** | **Additional  Paid-in-Capital** | ** ** | **Accumulated  Deficit** | ** ** | **Stockholders’  Equity** | ** **  | **Comprehensive  Loss** | ** ** |
|                                                                        |       |                  |       |                |       |                            |       |                     |       |                           |        |   |   |
| Balance, March 31, 2005                                                |       | 34,998,877            |       | $                   | 349,988    |                            | $          | 74,987,548               |       | $                              | (62,496,192 | ) | $ | 12,841,344 |   |   |   |
| Exercise of stock options, net                                              |       | 134,720               |       | 1,347               |       | 144,218                         |       | —                   |       | 145,565                        |        |   |   |
| Receipt of subscription receivable for shares sold February 2005,  net |       |                  |       |                |       | 55,869                          |       |                     |       | 55,869                         |        |   |   |
| Compensation expense related to non-employee  non-qualified stock options   |       |                  |       |                |       | 139,163                         |       | —                   |       | 139,163                        |        |   |   |
| Compensation expense related to employee  non-qualified stock options       |       |                  |       |                |       | 249,153                         |       |                     |       | 249,153                        |        |   |   |
| Net loss                                                                    |       | —                |       | —              |       | —                          |       | (2,912,013               | )          | (2,912,013                     | )           | $ | (2,912,013 | ) |
|                                                                        |       |                  |       |                |       |                            |       |                     |       |                           |        |   |   |
| Total comprehensive loss                                                    |       |                  |       |                |       |                            |       |                     |       |                           |        | $ | (2,912,013 | ) |
|                                                                        |       |                  |       |                |       |                            |       |                     |       |                           |        |   |   |
| Balance December 31, 2005                                              |       | 35,133,597            |       | $                   | 351,335    |                            | $          | 75,575,951               |       | $                              | (65,408,205 | ) | $ | 10,519,081 |   |   |   |

 

See accompanying notes to consolidated financial statements.

 

5

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**VISION-SCIENCES, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTSOF CASH FLOWS(Unaudited)**

 
| ** **                                                                    | ** ** | **Nine Months Ended  December 31, 2005** | ** ** | **Nine Months Ended  December 31, 2004** | ** ** |
|-------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|-----------------------------------------------|------------|
| Cash flows from operating activities:                                         |       |                                          |       |                                          |       |
| Net loss                                                                      |       | $                                             | (2,912,013 | )                                             | $          | (1,992,639 | ) |
| Adjustments to reconcile net loss to net cash used  for operating activities: |       |                                          |       |                                          |       |
| Depreciation and amortization                                                 |       | 328,498                                       |       | 216,899                                       |       |
| Stock compensation for non-qualified options                                  |       | 388,316                                       |       | 132,895                                       |       |
| Changes in assets and liabilities:                                            |       |                                          |       |                                          |       |
| Accounts receivable                                                           |       | (300,759                                      | )          | 62,199                                        |       |
| Inventories                                                                   |       | (392,345                                      | )          | (398,580                                      | )          |
| Prepaid expenses and deposits                                                 |       | (11,483                                       | )          | 20,231                                        |       |
| Accounts payable                                                              |       | 212,122                                       |       | (61,518                                       | )          |
| Accrued expenses                                                              |       | (136,859                                      | )          | 174,793                                       |       |
|                                                                          |       |                                          |       |                                          |       |
| Net cash used for operating activities                                        |       | (2,824,523                                    | )          | (1,845,720                                    | )          |
|                                                                          |       |                                          |       |                                          |       |
| Cash flows used for investing activities                                      |       |                                          |       |                                          |       |
| Purchase of property and equipment, net                                       |       | (318,112                                      | )          | (530,655                                      | )          |
| Increase in other assets                                                      |       | —                                        |       | (14,452                                       | )          |
|                                                                          |       |                                          |       |                                          |       |
| Net cash used for investing activities                                        |       | (318,112                                      | )          | (545,107                                      | )          |
|                                                                          |       |                                          |       |                                          |       |
| Cash flows provided by (used for) financing  activities:                      |       |                                          |       |                                          |       |
| Payments on note payable for computer equipment                               |       | (18,493                                       | )          | (12,959                                       | )          |
| Proceeds from acceptances payable to a bank                                   |       | 24,266                                        |       | 8,118                                         |       |
| Proceeds from the sale of common stock, net                                   |       | 55,869                                        |       | —                                        |       |
| Exercise of stock options, net                                                |       | 145,565                                       |       | 370,521                                       |       |
| Net cash provided by financing activities                                     |       | 207,207                                       |       | 365,680                                       |       |
|                                                                          |       |                                          |       |                                          |       |
| Net decrease in cash and cash equivalents                                     |       | (2,935,428                                    | )          | (2,025,147                                    | )          |
| Cash and cash equivalents, beginning of period                                |       | 9,868,586                                     |       | 2,714,941                                     |       |
| Cash and cash equivalents, end of period                                      |       | $                                             | 6,933,158  |                                          | $          | 689,794 |   |
|                                                                          |       |                                          |       |                                          |       |
| Supplemental Disclosure of Cash Flow Information:                             |       |                                          |       |                                          |       |
| Cash paid during the period for interest                                      |       | $                                             | 2,549      |                                          | $          | 3,891 |   |
|                                                                          |       |                                          |       |                                          |       |
| Supplemental Disclosure of Non-cash Items from  Financing Activities:         |       |                                          |       |                                          |       |
|                                                                          |       |                                          |       |                                          |       |
| Fair market value of non-qualified options granted  in the period             |       | $                                             | 1,124,124  |                                          | $          | 371,101 |   |

 

See accompanying notes to consolidated financial statements.

 

6

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**VISION-SCIENCES, INC. AND SUBSIDIARIESNOTES TO CONSOLIDATEDFINANCIAL STATEMENTS(Unaudited)**

 

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

 

Theconsolidated financial statements included herein have been prepared by Vision-Sciences, Inc.and subsidiaries (the “Company”) in accordance with accounting principlesgenerally accepted in the United States of America, without audit, pursuant tothe rules and regulations of the Securities and Exchange Commission andinclude, in the opinion of management, all adjustments (consisting only ofnormal and recurring adjustments) that the Company considers necessary for afair presentation of such information. Certain information and footnote disclosures normally included infinancial statements have been condensed or omitted pursuant to such rules andregulations.  The Company believes,however, that its disclosures are adequate to make the information presentednot misleading.  These consolidatedfinancial statements should be read in conjunction with the auditedconsolidated financial statements and notes thereto included in the Company’slatest annual report to stockholders. The results for the interim periods presented are not necessarilyindicative of results to be expected for the full fiscal year.

 

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

 

Theaccompanying consolidated financial statements reflect the application ofcertain 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 consist of a money marketaccount at a bank, and investments in commercial paper.  Cash equivalents are short-term highly liquidinvestments with original maturities of less than three months, and are carriedat amortized cost, which approximates market value*.*

 

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

 
| ** **      | ** ** | **December 31,  2005** | ** ** | **March 31,  2005** | ** ** |
|-----------------|------------|-----------------------------|------------|--------------------------|------------|
| ** **      | ** ** | ** **                  | ** ** | **(audited)**            | ** ** |
|            |       |                        |       |                     |       |
| Raw materials   |       | $                           | 1,519,279  |                     | $          | 1,166,946 |   |
| Work-in-process |       | 186,391                     |       | 253,449                  |       |
| Finished goods  |       | 563,499                     |       | 456,429                  |       |
|            |       | $                           | 2,269,169  |                     | $          | 1,876,824 |   |

 

Work-in-processand finished goods inventories consist of material, labor, and manufacturingoverhead.

 

7

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d.                                      *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                    |       |

 

Leaseholdimprovements are amortized over the shorter of their estimated useful lives orthe lives of the leases.

 

e.                                       *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.

 

f.                                         *Revenue Recognition*: The following must occur before theCompany recognizes revenue: (1) persuasive evidence of an arrangementexists, (2) delivery has occurred or services have been rendered, (3) theprice is fixed or determinable, (4) collectibility is reasonably assuredand (5) the fair value of undelivered elements, if any, exists.  To date the Company has not entered into anymultiple element arrangements.  TheCompany recognizes revenue when title passes to the customer, generally uponshipment of products F.O.B. shipping point. Since September 2003, the Company’s medical segment has distributedall of its products for the Ear-Nose-Throat (“ENT”) market in the U.S.A. andCanada through an agreement (the “Medtronic Agreement”) with Medtronic ENT, Inc.(formerly known as “Medtronic Xomed”) (“MENT”). The initial term of the Medtronic Agreement was three years, renewablethereafter annually, unless terminated by either party.

 

During the fiscal year ended March 31, 2005 (“FY05”), the Company and MENT modified the Medtronic Agreement to provide for arebate to MENT for sales of ENT EndoSheaths to new customers who commit tolarge purchases.  The rebate program wasdesigned to run for one year to September 30, 2005.  The Company accounted for this modificationunder Emerging Issues Task Force (“EITF”) 01-9, *Accountingfor Consideration Given by a Vendor to a Customer (Including a Reseller of theVendor’s Products)*.  As of December 31,2005, the Company and MENT terminated the rebate program.  As part of the termination, the Companyrecognized revenue of approximately $60,000 that had been deferred under therebate program in prior fiscal quarters.

 

8

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Since December 2004, the Company’s medicalsegment has distributed all of its products for the urology market in theU.S.A. and Canada through an agreement (the “MGU Agreement”) with Medtronic USA, Inc.(“MGU”).  The term of the MGU Agreement isthrough March 31, 2006, renewable for successive one-year periods unlesseither party notifies the other party in writing at least 90 days prior to theend of any term that it does not want to renew.

 

Neither the Medtronic Agreement nor the MGU Agreementprovide for any contingencies, nor provide any terms related to productacceptance or warranty that are different from the normal terms provided by theCompany to its other customers.

 

g.                                      *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.

 

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

 

TheCompany has recorded a valuation allowance equal to its net deferred tax assetdue to the uncertainty of realizing the benefit of this asset.

 

i                                             *Accounting for Options Issued to Non-employees: *During FY 05, the Company grantedoptions to purchase 150,000 shares of the Company’s Common Stock tonon-employees.  The fair value of theseoptions measured at the option grant dates was approximately $371,000,determined using the Black-Scholes option-pricing model, and is being recordedas an expense over the vesting period. The assumptions used in the Black-Scholes option-pricing model by theCompany were as follows:

 
| Risk-free interest rate                 |   | .93% - 1.36% |   |
|-----------------------------------------|--------|--------------|--------|
|                                    |   |         |   |
| Expected dividend yield                 |   | —       |   |
|                                    |   |         |   |
| Expected lives                          |   | 5 years      |   |
|                                    |   |         |   |
| Expected volatility                     |   | 79% - 83%    |   |
|                                    |   |         |   |
| Weighted average value grants per share |   | $            | 3.81   |   |
|                                         |        |              |        |  |

 

9

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Duringthe three months ended December 31, 2005 and 2004, the Company recognized$46,387 and $62,546, respectively, of expense related to such options.  During the nine months ended December 31,2005 and 2004, the Company recognized $139,163 and $123,004, respectively, ofexpense related to such options.

 

j.                                          *Employee Stock-based Compensation Arrangements:*The Companyaccounts for its stock-based compensation arrangements for employees andindependent directors using the intrinsic value method under the provisions ofAccounting Principles Board (“APB”) Opinion No. 25, *Accountingfor Stock Issued to Employees*, and Financial Interpretation No. (“FIN”)44.  The Company does not recognizestock-based compensation cost when the options granted have an exercise priceequal to, or greater than, the market value of the underlying common stock onthe date of the grant.  The Company doesrecognize stock-based employee compensation cost when the options granted havean exercise price less than the market value of the underlying common stock onthe date of the grant.

 

InJune 2003, the Company granted options to purchase 1,295,000 shares ofcommon stock to its employees 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 and nine monthsended December 30, 2004, the Company recognized $3,297 and $9,891,respectively, of expense related to these options as stock-based compensationin the consolidated statements of operations.

 

In September 2005, the U.S. Treasury Departmentand Internal Revenue Service issued proposed regulations under Section 409Aof the Internal Revenue Code (“Section 409A”), which was enacted as partof the American Jobs Creation Act of 2004. The proposed regulations covering Section 409A provide that stockoptions that vest after December 31, 2004 may be subject to Section 409Aas “deferred compensation” if the exercise price is below the fair market valueof the underlying stock on the date of grant. Unless discounted stock options are amended, the stock options will notbe compliant with Section 409A and will likely result in incomerecognition prior to exercise (i.e., at the time of vesting), an additional 20%income tax and potential interest charges.

 

Inorder to comply with section 409A, the Company and the subject employeesagreed to amend the original option by issuing two amended options.  One option is for the shares that had vestedas of December 31, 2004.  Thisoption has no change to the option price, and did not have any accountingeffect.  This option amended the numberof shares to be equal to the number that had vested as of December 31,2004.

 

10

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Thesecond option is for shares that vest after December 31, 2004, and have anew option price equal $1.09 per share, the fair market value of the underlyingcommon stock on June 3, 2003, the original date of the option, bringingthem into compliance with Section 409A. According to EITF 00-23, this option has an accounting effect, due tothe change in the measurement date.  Thefair market value of the common stock on December 30, 2005, the date ofgrant, was $2.08 per share. 

 

TheCompany will account for this change according to APB 25 by recognizingcompensation expense equal to the difference between the fair market value pershare and the option price in the three months ended December 31, 2005 andin the three months ending March 31, 2006. In the three months ended December 31, 2005, the Company recognized$252,450 of stock-based compensation expense, the total amount of thecompensation for calendar 2005. In the three months ending March 31, 2006,the Company will recognize $63,113 of stock-based compensation expense relatedto these options. Subsequent to March 31, 2006, the Company will recognizestock-based compensation for the unvested options under FAS 123R.

 

Inthe three months ended September 30, 2005, the Company grantednon-qualified options to purchase 4,000 shares of the Company’s Common Stock toeach of three of its independent directors, as provided for in the Company’s2003 Director Option Plan.  The optionswere granted at exercise prices equal to the fair market value of theunderlying common stock on the dates of grant.

 

Inaccordance with the Financial 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 the disclosure requirements of FASB No. 148.  Had compensation expense for all stock optiongrants to employees and independent directors been determined under the fairvalue method at the grant dates, consistent with the method prescribed by SFAS No. 123,the Company’s net loss would have been increased to the pro forma amountsindicated as follows:

 

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| ** **                                                     | ** ** | **Three Months Ended  December 31,** | ** ** | **Nine Months Ended  December 31,** | ** ** |
|----------------------------------------------------------------|------------|-------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                     | ** ** | **2005**                                  | ** ** | **2004**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net loss – as  reported                                   |       | $                                         | (1,002,369 | )                                        | $          | (786,222 | ) | $ | (2,912,013 | ) | $ | (1,992,639 | ) |
| Stock-based employee compensation – as reported  reported |       | 242,559                                   |       | 3,297                                    |       | 249,153 |   | 9,891 |   |
| Pro forma  stock-based employee compensation                   |       | (494,452                                  | )          | (103,900                                 | )          | (760,114 | ) | (301,900 | ) |
| Net loss – pro  forma                                     |       | $                                         | (1,254,262 | )                                        | $          | (886,825 | ) | $ | (3,422,974 | ) | $ | (2,284,648 | ) |
|                                                           |       |                                      |       |                                     |       |   |   |   |   |
| Net loss per  share – as reported                         |       | $                                         | (.03       | )                                        | $          | (.03 | ) | $ | (0.08 | ) | $ | (0.06 | ) |
| Stock-based  employee compensation – as reported          |       | —                                    |       | —                                   |       | — |   | — |   |
| Pro forma  stock-based employee compensation                   |       | (.01                                      | )          | —                                   |       | (0.02 | ) | (.01 | ) |
| Net loss per  share – pro forma                           |       | $                                         | (.04       | )                                        | $          | (.03 | ) | $ | (0.10 | ) | $ | (0.07 | ) |

 

k.                                       *New Accounting Standards:* In November 2004,the FASB issued SFAS No. 151, *Inventory Costs*,an amendment of ARB No. 43, Chapter 4. SFAS No. 151 amends the guidance in ARB No. 43, Chapter 4, *Inventory Pricing*, to clarify the accounting for abnormalamounts of idle facility expense, freight, handling costs and spoilage.  This statement requires that those items berecognized as current period charges regardless of whether they meet thecriterion of “so abnormal” which was the criterion specified in ARB No. 43.  In addition, this Statement requires thatallocation of fixed production overheads to the cost of production be based onnormal capacity of the production facilities. This pronouncement is effective for fiscal years beginning after June 15,2005.  The Company has not yet assessedthe impact of adopting this new standard.

 

In December 2004,the FASB issued SFAS No. 123 (revised 2004), *Share-BasedPayment*.  SFAS 123R is arevision of SFAS No. 123, *Accounting for Stock-BasedCompensation* and supersedes APB No. 25, *Accountingfor Stock Issued to Employees*, and its related implementationguidance.  SFAS 123R requires allshare-based payments to employees, including grants of employee stock options,to be recognized in the financial statements based on their fair values.  The pro forma disclosures previouslypermitted under SFAS 123 no longer will be an alternative to financialstatement recognition.  The Company isrequired to adopt SFAS 123R in the first quarter of the fiscal year ending March 31,2007, beginning April 1, 2006. Under SFAS 123R, the Company must determine the appropriate fair valuemodel to be used for valuing share-based payments, the amortization method for

 

12

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compensationcosts and the transition method to be used at date of adoption. The transitionmethods include prospective and retrospective adoption options.  Under the retroactive option, prior periodsmay be restated either as of the beginning of the year of adoption or for allperiods presented.  The prospectivemethod requires that compensation expense be recorded for all unvested stockoptions and restricted stock at the beginning of the first quarter of adoptionof SFAS 123R, while the retroactive method would record compensation expensefor all unvested stock options and restricted stock beginning with the firstperiod restated.  The Company isevaluating the requirements of SFAS 123R and expects that the adoption of SFAS123R may have a material impact on its consolidated results of operations andearnings per share.  The Company has notyet determined the method of adoption or the effect of adopting SFAS 123R, andit has not determined whether the adoption will result in amounts that aresimilar to the current pro forma disclosures under SFAS 123.

 

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**3.****                                     ****3BY Ltd.**

 

In June 2003,the Company entered into a Contract Manufacturing Agreement, a Loan Agreementand a Pledge Agreement (collectively, the “3BY Agreements”) with Three BY Ltd.,an Israeli company (“3BY”).  The 3BYAgreements provided for, among other things, the manufacture of certain of theCompany’s products by 3BY, and a loan of up to $267,500 by the Company to 3BYfor the purchase and installation of certain manufacturing equipment by 3BY, at3BY’s facility, to be used to manufacture certain of the Company’sproducts.  3BY completed the purchase andinstallation of the manufacturing equipment, and the Company began receivingcommercial production from 3BY in the three months ending September 30,2004.  On October 1, 2004, accordingto terms in the Loan Agreement, 3BY and the Company agreed that the Company wouldtake title to the manufacturing equipment, in lieu of 3BY retaining title andpaying back the advance.

 

In May 2005,the Company decided to bring the manufacturing of these products back to itsNatick, MA plant, due to the inability to exert sufficient control over themanufacturing processes to have the confidence level necessary for its productquality.  In addition, the costs savings thatthe Company anticipated have not been attained. On October 2, 2005, the Company and 3BY entered into a Terminationand Settlement Agreement (the “Termination Agreement”) pursuant to which theCompany and 3BY terminated the 3BY Agreements. Included in the Termination Agreement is a provision for the Company topurchase from 3BY 180,000 units of the Company’s basic ENT Slide-On EndoSheathat a price that represents an increase of approximately $62,000 in total,compared to the price paid prior to termination.  The Company expects that this purchase orderwill be completed over the next six to nine months.  In addition, the Company will pay 3BY $16,700for costs related to equipment purchased by 3BY.  After completion of the purchase order, theequipment owned by the Company located at 3BY’s facilities will be returned tothe Company’s Natick, MA plant.  To date,the Company does not believe these assets are impaired based upon theirintended use.

 

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**4.****                                     ****Segment Information**

 

TheCompany has three reportable segments – medical, industrial and corporate.  The medical segment designs, manufactures andsells EndoSheaths and sells endoscopes to users in the health care industry.  The industrial segment designs, manufactures andsells 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.

 

Allsegments follow the accounting policies described in the summary of significantaccounting policies.  The Companyevaluates 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.

 

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| **Three months ended December 31,** | ** ** | **Medical** | ** ** | **Industrial** | ** ** | **Corporate** | ** ** | **Adjustments** | ** ** | **Total**  | ** ** |
|------------------------------------------|------------|-------------|------------|----------------|------------|---------------|------------|-----------------|------------|------------|------------|
| **2005**                                 |       |        |       |           |       |          |       |            |       |       |       |
| Sales to external customers              |       | $           | 2,530,973  |           | $          | 799,068       |       | $               | —     |       | $          | — |   | $ | 3,330,041 |   |
| Intersegment sales                       |       | —      |       | 830,701        |       | —        |       | (830,701        | )          | —     |       |
| Operating income (loss)                  |       | (580,723    | )          | 21,270         |       | (497,232      | )          | —          |       | (1,056,685 | )          |
| Interest income (expense), net           |       | —      |       | —         |       | 55,506        |       | —          |       | 55,506     |       |
| Depreciation and amortization            |       | 118,143     |       | 4,283          |       | —        |       | —          |       | 122,426    |       |
| Other significant non-cash items:        |       |        |       |           |       |          |       |            |       |       |       |
| Stock-based compensation                 |       | 60,488      |       | —         |       | 228,459       |       | —          |       | 288,947    |       |
| Expenditures for fixed assets            |       | 108,856     |       | 10,371         |       | —        |       | —          |       | 119,227    |       |
|                                     |       |        |       |           |       |          |       |            |       |       |       |
| **2004**                                 |       |        |       |           |       |          |       |            |       |       |       |
| Sales to external customers              |       | $           | 2,158,084  |           | $          | 668,865       |       | $               | —     |       | $          | — |   | $ | 2,826,949 |   |
| Intersegment sales                       |       | —      |       | 838,159        |       | —        |       | (838,159        | )          | —     |       |
| Operating income (loss)                  |       | (338,623    | )          | (26,896        | )          | (429,148      | )          | —          |       | (794,667   | )          |
| Interest income (expense), net           |       | —      |       | —         |       | 2,672         |       | —          |       | 2,672      |       |
| Depreciation and amortization            |       | 76,379      |       | 14,664         |       | 1,506         |       | —          |       | 92,549     |       |
| Other significant non-cash items:        |       |        |       |           |       |          |       |            |       |       |       |
| Stock-based compensation                 |       | 62,734      |       | 62             |       | 3,047         |       | —          |       | 65,843     |       |
| Conversion of advance to fixed asset     |       | 267,500     |       | —         |       | —        |       | —          |       | 267,500    |       |
| Expenditures for fixed assets            |       | 131,694     |       | —         |       | —        |       | —          |       | 131,694    |       |

 
| **Nine months ended December 31,** | ** ** | **Medical** | ** ** | **Industrial** | ** ** | **Corporate** | ** ** | **Adjustments** | ** ** | **Total**  | ** ** |
|-----------------------------------------|------------|-------------|------------|----------------|------------|---------------|------------|-----------------|------------|------------|------------|
| **2005**                                |       |        |       |           |       |          |       |            |       |       |       |
| Sales to external customers             |       | $           | 6,147,281  |           | $          | 2,017,270     |       | $               | —     |       | $          | — |   | $ | 8,164,551 |   |
| Intersegment sales                      |       | —      |       | 2,246,594      |       | —        |       | (2,246,594      | )          | —     |       |
| Operating income (loss)                 |       | (1,929,099  | )          | (6,246         | )          | (1,120,846    | )          | —          |       | (3,056,191 | )          |
| Interest income (expense), net          |       | —      |       | —         |       | 140,568       |       | —          |       | 140,568    |       |
| Depreciation and amortization           |       | 300,545     |       | 27,953         |       | —        |       | —          |       | 328,498    |       |
| Other significant non-cash items:       |       |        |       |           |       |          |       |            |       |       |       |
| Stock-based compensation                |       | 153,762     |       | —         |       | 234,554       |       | —          |       | 388,316    |       |
| Expenditures for fixed assets           |       | 291,871     |       | 26,241         |       | —        |       | —          |       | 318,112    |       |
| Total assets                            |       | 3,831,816   |       | 2,057,996      |       | 7,019,113     |       | (402,303        | )          | 12,506,622 |       |
|                                    |       |        |       |           |       |          |       |            |       |       |       |
| **2004**                                |       |        |       |           |       |          |       |            |       |       |       |
| Sales to external customers             |       | $           | 5,265,728  |           | $          | 2,369,439     |       | $               | —     |       | $          | — |   | $ | 7,635,167 |   |
| Intersegment sales                      |       | —      |       | 1,815,373      |       | —        |       | (1,815,373      | )          | —     |       |
| Operating income (loss)                 |       | (1,008,495  | )          | (58,463        | )          | (951,158      | )          | —          |       | (2,018,116 | )          |
| Interest income (expense), net          |       | —      |       | —         |       | 16,045        |       | —          |       | 16,045     |       |
| Depreciation and amortization           |       | 175,148     |       | 37,233         |       | 4,518         |       | —          |       | 216,899    |       |
| Other significant non-cash items:       |       |        |       |           |       |          |       |            |       |       |       |
| Stock-based compensation                |       | 123,567     |       | 187            |       | 9,141         |       | —          |       | 132,895    |       |
| Conversion of advance to fixed asset    |       | 267,500     |       | —         |       | —        |       | —          |       | 267,500    |       |
| Expenditures for fixed assets           |       | 508,505     |       | 22,150         |       | —        |       | —          |       | 530,655    |       |
| Total assets                            |       | 3,394,262   |       | 1,456,707      |       | 777,249       |       | (280,433        | )          | 5,347,785  |       |

 

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

## ** **

**Executive Summary**

 

This QuarterlyReport on Form 10-Q contains forward-looking statements within the meaningof The Private Securities Litigation Reform Act of 1995.  Examples of forward-looking statementsinclude statements about expectations about future financial results, futureproducts and future sales of new and existing products, future expenditures,and capital resources to meet anticipated requirements.  Without limiting the foregoing, the words “believes”,“anticipates”, “plans”, “expects”, and similar expressions are intended toidentify forward-looking statements. These forward-looking statements involve risks and uncertainties, andour actual results may differ significantly from those discussed in theforward-looking statements. Factors that might cause such a difference include,but are not limited to, the availability of capital resources, the availabilityof third-party reimbursement, government regulation, the availability ofsupplies, competition, technological difficulties, the continuation of ourcontracts with MENT and MGU, general economic conditions and other risksdetailed in our most recent Annual Report on Form 10-K and any subsequentperiodic filings made 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, manufactureand sell endoscope products for the medical device and industrial devicemarkets.  We operate in three reportingsegments, medical, industrial and corporate.

 

#### *Medical Segment*

#### * *

The medical segmentsupplies flexible endoscopes and disposable Slide-OnTM EndoSheath® Systems (“EndoSheaths”)to the ENT, urology, gastrointestinal (“GI”) and pulmonary markets.  Health-care providers use EndoSheaths tocover the insertion tube of flexible endoscopes, such as ENT endoscopes,Trans-Nasal Esophagoscopes (“TNE”), cystoscopes, sigmoidoscopes andbronchoscopes.  We have designed theEndoSheaths to allow the health-care providers to process patients economicallyby permitting the providers to minimize reprocessing the endoscopes betweenprocedures.  In addition, the EndoSheathsensure a sterile insertion tube for each patient procedure.

 

Our strategy in themedical segment is comprised of three components: a) improve salesdistribution, b) lower manufacturing costs and c) increase the number of newproduct offerings.

 

#### *Sales Distribution*

#### * *

SinceSeptember 19, 2003, we have been distributing all of our products for theENT market in the U.S.A. and Canada through MENT as part of the MedtronicAgreement. The initial term of the Medtronic Agreement is three years.  Thereafter, the Medtronic Agreement isautomatically renewed for successive one-year periods, unless terminated byeither party upon advance written notice. Under the Medtronic Agreement, we have granted MENT exclusivedistribution rights in the U.S.A. and Canada to market and sell our ENT and TNEEndoSheaths and endoscopes to ENT practitioners.  MENT fulfilled certain minimum purchaserequirements for the initial twelve-month period of the term.  The Medtronic Agreement resulted in anincrease in sales of our ENT EndoSheaths and ENT endoscopes due to the quantitiesof endoscopes and EndoSheaths purchased by Medtronic Xomed in the initialtwelve-month period.  In the second year(“Year 2”) of the Medtronic Agreement, MENT

 

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purchasedfewer units of ENT endoscopes and ENT EndoSheaths than in the initial period,due to the build up of inventory that resulted from the purchases in theinitial period.  During Year 2, we and MENTbegan a rebate program, whereby we agreed to pay MENT a cash rebate for ENTEndoSheaths they sold to new users who committed to a large annual purchase. Asof September 30, 2005, we recorded a reserve of approximately $62,000 forthe rebate program.  As of September 30,2005, MENT had depleted their excess inventory, and had ordered ENT EndoSheathsat an annual rate of over 150,000 units. We terminated the rebate program during the three months ending December 31,2005.  As part of that termination, werecognized approximately $60,000 of revenue that we had reserved for in priorfiscal quarters.

 

Inaddition, in December 2004, we signed the MGU Agreement with MGU, thegastro-urology division of Medtronic, Inc., granting MGU exclusive rightsto distribute our new cystoscope with Slide-On EndoSheath System to urologistsin the U.S.A. and Canada.  The term ofthe MGU Agreement is through March 31, 2006, renewable for successiveone-year periods unless either party notifies the other party in writing atleast 90 days prior to the end of any term that it does not want to renew.  The total purchase commitment for cystoscopesand Slide-On EndoSheaths is $1,965,000, of which $353,500 was to be deliveredin the fiscal year ended March 31, 2005 (“FY 05”), and the remainder in thefiscal year ending March 31, 2006 (“FY 06”).  We expect MGU will purchase approximately$1,057,000 of urology products in FY 06, less than their purchasecommitment.  Penetrating the urologymarket has proven more difficult than either party had expected, due primarilyto the time required to train physicians, recruit and train a sales force andprice considerations.  We expect tocontinue to partner with MGU to the end of FY 06.  At that time we will assess whether we willcontinue to partner with MGU, or look for another distribution channel.

 

Webelieve the marketing and sales capabilities of MENT has facilitated and willcontinue to facilitate the introduction of new products to the ENT markets byallowing quicker market acceptance of these products than if we marketed themourselves.  To date, we believe themarketing and sales abilities of MGU have facilitated a limited introduction ofour products to the urology market.  Atthe end of FY 06 we and MGU will assess the market situation to determine ifthe outlook for the future is sufficiently encouraging for both parties tocontinue the relationship.  As a resultof these agreements, the success of our ENT and urology product lines issubstantially dependent upon the success of the marketing and sales activitiesof MENT and MGU, over which we have limited control.  We have retained our domestic network ofindependent sales representatives for the GI and pulmonary product lines.  Also, we have retained our own internationalnetwork of distributors for all our medical product lines.

 

#### *Cost Reduction*

#### * *

DuringFY 06, we have started the implementation of reductions in the cost ofmaterials and labor across our endoscope and EndoSheath product lines byexamining, modifying and updating our material costs and labor processes.  In addition, we are working on a developmentproject for a new low-cost

 

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EndoSheaththat we expect will result in a new EndoSheath design and machinery that will leadto automating processes in the manufacturing of EndoSheaths.  We continue to work on this development project,and expect if we purchase the automated machinery, we will have it in placeapproximately six to nine months after order placement.

 

#### *New Products*

#### * *

InMay 2005, we received clearance from the FDA to market our new ENT-3000portable endoscope with rechargeable battery-powered LED light source.  During FY 06, our product development plans haveincluded our design efforts for a new low-cost EndoSheath concept, described in*Cost Reduction* above.  In addition, we are designing a new family ofsmaller sized “D-shaped” proprietary endoscopes for use with our EndoSheathsthat incorporate channels, and a new family of videoscopes with a distal tipCCD-based camera.  We also plan toinvestigate other potential products for the cardiac, gastrointestinal and orthopedicsurgery markets.

 

#### *Industrial Segment*

#### * *

The industrial segmentdesigns, manufactures and sells flexible endoscopes, termed borescopes, forindustrial users, and manufactures and repairs flexible endoscopes for themedical segment.  The industrial segmentusers consist primarily of companies in the aircraft engine manufacturing andmaintenance markets, and the defense market.

 

#### *Corporate Segment*

#### * *

The corporate segmentconsists of certain administrative and business development activitiesapplicable to the Company as a whole.

 

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Critical Accounting Policies and Estimates

 

This discussion andanalysis of our financial condition and results of operations is based upon ourConsolidated Financial Statements, which have been prepared in accordance withaccounting principles generally accepted in the United States.  See the Notes to the Consolidated FinancialStatements included elsewhere herein. Certain of our accounting policies require the application of judgmentin selecting the appropriate assumptions for calculating financialestimates.  By their nature thesejudgments 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:

 

### *Revenue Recognition*

### * *

We recognize revenue inaccordance with SEC Staff Accounting Bulletin No. 104, *Revenue Recognition in Financial Statements*and EITF 00-21, *Revenue Arrangements with Multiple 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) collectibilityis reasonably assured and (5) the fair value of undelivered elements, ifany, exists.  Determination of criterion (4) isbased on management’s judgment regarding the collectibility of invoices forproducts and services delivered to customers. Should changes in conditions cause management to determine thesecriteria are not met for certain future transactions, revenue recognized forany reporting period could be adversely affected.

 

We account for the rebatewe granted to MENT in accordance with EITF 01-9, *Accountingfor Consideration Given by a Vendor to a Customer (Including a Reseller of theVendor’s Products)*.  Thispronouncement requires that a vendor recognize rebates as a reduction ofrevenue based on a systematic and rational allocation of the cost of honoringrebates earned and claimed to each of the underlying revenue transactions thatresult in progress by the customer toward earning the rebate.  Accordingly, as of September 30, 2004,we recognized an allowance of $39,000 for the estimated rebate that wouldaccrue to MENT for sales of ENT EndoSheaths that were in MENT’s inventory atthat date that would be sold to new customers under the rebate program.  Subsequent to September 30, 2004, werecognize revenue on sales of ENT EndoSheaths to MENT, net of an estimatedsales allowance related to that rebate program. Measurement of the total rebate is based on the estimated number of customers that willultimately earn rebates under the offer. Determination of the number of customers that will earn rebates and theamount of those rebates is based on management’s judgment.  We reviewed our estimates of the number ofcustomers that will earn benefits under the rebate program each fiscalquarter.  In the fiscal quarter ended December 31,2005 we terminated the rebate program, and recognized approximately $60,000 ofrevenue deferred in prior quarters.

 

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*Options Issued to Non-employees*

 

We account fornon-qualified options issued to non-employees as equity instruments, inaccordance with the provisions of EITF 96-18. Fair values for these non-qualified options are derived from pricingmodels that consider current market and contractual prices for the underlyingfinancial instruments, as well as time value, yield curve and volatilityfactors underlying the positions. Pricing models and their underlying assumptions impact the amount andtiming of the value of these non-qualified options, and the use of differentpricing models or assumptions could produce different financial results.  We use the Black-Scholes option-pricing modelfor determining the value of non-qualified options issued to non-employees, andwe expense that value over the vesting period of the non-qualified options.

 

We account for certainnon-qualified options granted to employees and independent members of our Boardof Directors to purchase our common stock in accordance with APB Opinion No. 25,*Accounting for**Stock Issuedto Employees.*  If the fairmarket value of the underlying stock at the date of grant is greater than theoption price, we recognize compensation expense for the difference between themarket price and the option price over the vesting period of the options.

 

*IncomeTaxes*

 

Under our income taxpolicy, we record the estimated future tax effects of temporary differencesbetween the tax bases of assets and liabilities and amounts recorded in theaccompanying consolidated balance sheets, as well as operating loss and taxcredit carryforwards.  The evaluation ofthe recoverability of any tax assets recorded on the balance sheet is subject tosignificant judgment.  We have providedvaluation allowances for all our deferred tax assets to date.

 

**Resultsof Operations**

 

Net Sales

 

*Q3 06 Compared to Q3 05*

 

Net sales for thethree months ended December 31, 2005 (“Q3 06”) were $3,330,041, an increaseof $503,092, or 18%, compared to the three-month period ended December 31,2004 (“Q3 05”).  During Q3 06, net salesof the medical segment increased by $372,889, or 17%, to $2,530,973, and netsales of the industrial segment increased by $130,203, or 19%, to $799,068, comparedto Q3 05.  In the medical segment, the netsales and changes in net sales by market were as follows ($000’s):

 
| **Market** | ** ** | **Q3 06** | ** ** | **Q3 05** | ** ** | **Increase  (Decrease)** | ** ** | **Percent** | ** ** |
|------------|------------|-----------|------------|-----------|------------|--------------------------|------------|-------------|------------|
| ENT        |       | $         | 1,650      |      | $          | 1,628                    |       | $           | 22         |   | 1 | % |
| Urology    |       | 457       |       | 263       |       | 194                      |       | 74          | %          |
| Other      |       | 424       |       | 267       |       | 157                      |       | 59          | %          |
| Total      |       | $         | 2,531      |      | $          | 2,158                    |       | $           | 373        |   | 17 | % |

 

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*MedicalSales – ENT Market*

 

Net sales to the ENTmarket include products for domestic and international customers as follows:

 
| **ENT Market** | ** ** | **Q3 06** | ** ** | **Q3 05** | ** ** | **Increase (Decrease)** | ** ** | **Percent** | ** ** |
|----------------|------------|-----------|------------|-----------|------------|-------------------------|------------|-------------|------------|
| Domestic       |       | $         | 790        |      | $          | 1,062                   |       | $           | (272       | ) | (26 | )% |
| International  |       | 860       |       | 566       |       | 294                     |       | 52          | %          |
| Total ENT      |       | $         | 1,650      |      | $          | 1,628                   |       | $           | 22         |   | 1 | % |

 

We further delineateproducts sold to the domestic ENT market as follows:

 
| **ENT Products**     | ** ** | **Q3 06** | ** ** | **Q3 05** | ** ** | **Increase  (Decrease)** | ** ** | **Percent** | ** ** |
|----------------------|------------|-----------|------------|-----------|------------|--------------------------|------------|-------------|------------|
| Slide-On EndoSheaths |       | $         | 384        |      | $          | 151                      |       | $           | 233        |   | 154 | % |
| Endoscopes           |       | 406       |       | 911       |       | (505                     | )          | (55         | )%         |
| Total Domestic ENT   |       | $         | 790        |      | $          | 1,062                    |       | $           | (272       | ) | (26 | )% |

 

Theprimary reason for the decrease in sales of products to the domestic ENT marketwas lower sales of TNE D endoscopes to MENT and the non-recurring sale to MENT inQ3 05 of TNE therapeutic (“TNE Bx”) endoscopes of $461,000.  Our TNE D endoscopes and companion TNEEndoSheath are utilized by ENT physicians to observe and diagnose ailments inthe esophagus.  TNE is a relatively newprocedure for ENT physicians.  Normally,a patient experiencing Gastro Esophageal Reflux Disease, (“GERD”) would bereferred to a GI physician who may perform a gastroscopy exam.  This procedure involves the insertion of agastroscope orally into the esophagus, thus requiring conscious sedation,typically in a hospital.  Using a TNE Dendoscope allows insertion to be done nasally, with local anesthesia, thusavoiding a trip to the hospital and the complications of conscioussedation.  However, the education andtraining of ENT physicians to the benefits of TNE takes time.  We expect sales of our TNE D endoscope andEndoSheath will grow over time, especially with the incidence of GERD in an agingpopulation.

 

OurTNE Bx endoscopes and companion EndoSheath are designed to be used by ENTphysicians to take biopsies of tissue observed during an endoscopy.  The education and training of ENT physiciansfor this procedure will take longer than for the diagnostic procedure, and wedo not expect sales of our TNE Bx endoscope and companion EndoSheath to grow asfast in the near future as sales of the TNE D products.  Over time we expect ENT physicians willutilize both procedures, allowing us to combine the two products into one thatcan perform both procedures economically.

 

Totalsales to MENT in Q3 06 were $1.014 million, a decrease of approximately $0.138million, or 12%, compared to $1.152 million in Q3 05, due primarily to the lowersales of TNE D and TNE Bx endoscopes referred to above.  Partially offsetting the lower sales of TNEendoscopes in Q3 06 were higher sales of ENT endoscopes and ENT Slide-OnEndoSheaths (“ENT SOS”) to MENT.  In Q306, MENT purchased 93 ENT endoscopes and 49,000 ENT SOS, an increase of 48units and 34,000 units, respectively, compared to Q3 05.

 

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AlthoughMENT has not purchased the required number of ENT EndoSheaths to maintain theirexclusivity under the Medtronic Agreement, we have not exercised our right toterminate their exclusivity, as we believe their sales of our products will continueto improve, and we currently believe they represent the best alternative for usto distribute our current line of ENT products and drive product acceptance ofnew ENT and TNE products in the domestic market.  MENT is selling approximately 34% more unitsof ENT SOS than we sold before we entered into the Medtronic Agreement.

 

InFY 06, we and MENT have introduced a more attractive pricing program for theENT SOS, allowing the price for all new purchases to decline in steps.  The first 150,000 units of ENT SOS purchasedby MENT will be at the contract price; the next 100,000 will be at the contractprice less $1.50 per unit; units over 250,000 will be at the contract priceless $2.00 per unit.  The purpose of thisprice schedule is to allow MENT to penetrate the market for largeinstitutions and sell ENT EndoSheaths to them at prices those institutions findreasonable.  In addition, we and MENT continueto discuss additional new programs that will increase the sales of our ENT andTNE products.

 

Asa result of the Medtronic Agreement, the success of our ENT product lines issubstantially dependent upon the success of the marketing and sales activitiesof MENT over which we have limited control.

 

We further delineateproducts sold to the international ENT market as follows:

 
| **ENT Products**     | ** ** | **Q3 06** | ** ** | **Q3 05** | ** ** | **Increase  (Decrease)** | ** ** | **Percent** | ** ** |
|----------------------|------------|-----------|------------|-----------|------------|--------------------------|------------|-------------|------------|
| Slide-On EndoSheaths |       | $         | 559        |      | $          | 381                      |       | $           | 178        |   | 47 | % |
| Endoscopes           |       | 301       |       | 185       |       | 116                      |       | 63          | %          |
| Total International  |       | $         | 860        |      | $          | 566                      |       | $           | 294        |   | 52 | % |

 

The increase in net salesto international distributors is primarily due to higher unit volume of ENT SOS,and higher volume of ENT endoscopes.  Unitsales of ENT SOS to the international distributors were 88,426 in Q3 06, an increaseof 29,506 units, compared to sales in Q3 05. The increase in sales was due to higher demand, especially in Europe,and to sales of ENT SOS to new distributors in the Middle East.  We expect unit demand from international distributorsto continue at this rate for the remainder of FY 06.

 

Unit sales of ENTendoscopes in Q3 06 to international distributors were 76, compared to 39 in Q305.  The primary reason for the increasewas the introduction of our new ENT-3000 endoscope with portable light sourceto the international market.  Inaddition, we sold 2 TNE D endoscopes and 3 TNE Bx endoscopes to ourinternational distributors in Europe.  Weare in the early stages of selling TNE endoscopes to our distributors, and weplan to increase our sales of this product by increasing the number ofdistributors in countries where we do not have representation.  However, there can be no assurance we will beable to consummate these agreements on terms that are beneficial to us. Also,we expect sales of TNE endoscopes will improve after we release the new smallerD-shaped fiberscope and new videoscope in the fiscal year ending March 31,2007. 

 

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Sales of endoscopes aredependent upon a variety of factors, including the timing requirements of endusers, foreign exchange rates, sales promotions of international competitorsand other factors.

 

*MedicalSales – Urology*

 

The increase in sales ofurology products reflects primarily increased shipments of our new FlexibleCystoscope (“CST-2000”) with Slide-On EndoSheath System to MGU, offsetpartially by lower shipments to international distributors.  We sold approximately $408,000 of CST-2000and Slide-On EndoSheaths to MGU in Q3 06, and approximately $49,000 tointernational distributors, compared to $124,000 and $139,000 in Q3 05,respectively.  We expect sales of the CST-2000to MGU will be lower in the fiscal quarter ending March 31, 2006 comparedto sales in Q3 06.  This is due to the buildupof inventory at MGU while they continue to train MGU sales personnel to moreeffectively penetrate the cystoscopy market. Sales of urology products to the international market were lower in Q306, compared to Q3 05, due primarily to state medical officials in Australia dictatingthat our cystoscopes be reprocessed and disinfected even when our EndoSheath isused.  In addition, our distributor inthe United Kingdom acquired a company with a conventional product solution,eliminating their interest in our products. We continue to promote our solution to other countries, and in Q3 06succeeded in selling to distributors in France, Italy and Sweden.  We will continue to promote our cystoscopeand EndoSheath System in other countries, but there can be no assurance we willbe successful.

 

We believe the CST-2000and EndoSheath System can significantly enhance the practice efficiency ofurologists by allowing them to avoid the tedious and time-consumingreprocessing of conventional cystoscopes, and presents the significant benefitof a sterile insertion tube for each patient. In addition, the use of our CST-2000 with Slide-On EndoSheath Systemavoids the need to reprocess endoscopes with harsh chemicals, one of which hasbeen contraindicated for use on patients with bladder cancer.  The incidence of bladder cancer, according tothe National Cancer Institute, is rising, with more than 63,000 men and womenin the United States and 330,000 worldwide in 2005 diagnosed with bladdercancer.

 

*IndustrialSegment*

 

The increase in net salesof the industrial segment was due to higher demand in the market for our lineof fiber borescopes, and for repairs of fiber borescopes.

 

*9 Months06 Compared to 9 Months 05*

 

Net sales for the ninemonths ended December 31, 2005 (“9M 06”) were $8,164,551, an increase of $529,384,or 7%, compared to net sales of $7,635,167 for the 9 months ended December 31,2004 (“9M 05”).  In 9M 06, sales of themedical segment were $6,147,281, an increase of $881,553, or 17%, compared tonet sales of $5,265,728 in 9M 05.  Also in9M 06, sales of the industrial segment were $2,017,270, a decrease of $352,169,or 15%, compared to net sales of $2,369,439 in 9M 05.  In the medical segment, net sales and changesin net sales by market were as follows ($000’s): 

 

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| **Market** | ** ** | **9M 06** | ** ** | **9M 05** | ** ** | **Increase  (Decrease)** | ** ** | **Percent** | ** ** |
|------------|------------|-----------|------------|-----------|------------|--------------------------|------------|-------------|------------|
| ENT        |       | $         | 4,093      |      | $          | 4,172                    |       | $           | (79        | ) | (2 | )% |
| Urology    |       | 959       |       | 358       |       | 601                      |       | 168         | %          |
| Other      |       | 1,095     |       | 736       |       | 359                      |       | 49          | %          |
| Total      |       | $         | 6,147      |      | $          | 5,266                    |       | $           | 881        |   | 17 | % |

 

*MedicalSales – ENT Market*

 

Sales to the ENT marketinclude products for the domestic and international customers as follows:

 
| **ENT Market** | ** ** | **9M 06** | ** ** | **9M 05** | ** ** | **Increase  (Decrease)** | ** ** | **Percent** | ** ** |
|----------------|------------|-----------|------------|-----------|------------|--------------------------|------------|-------------|------------|
| Domestic       |       | $         | 1,984      |      | $          | 2,640                    |       | $           | (656       | ) | (25 | )% |
| International  |       | 2,109     |       | 1,532     |       | 577                      |       | 38          | %          |
| Total ENT      |       | $         | 4,093      |      | $          | 4,172                    |       | $           | (79        | ) | (2 | )% |

 

We further delineateproducts sold to the domestic ENT market as follows:

 
| **ENT Products**     | ** ** | **9M 06** | ** ** | **9M 05** | ** ** | **Increase  (Decrease)** | ** ** | **Percent** | ** ** |
|----------------------|------------|-----------|------------|-----------|------------|--------------------------|------------|-------------|------------|
| Slide-On EndoSheaths |       | $         | 813        |      | $          | 1,101                    |       | $           | (288       | ) | (26 | )% |
| Endoscopes           |       | 1,171     |       | 1,539     |       | (368                     | )          | (24         | )%         |
| Total Domestic ENT   |       | $         | 1,984      |      | $          | 2,640                    |       | $           | (656       | ) | (25 | )% |

 

The primary reason forthe lower sales of ENT EndoSheaths to the domestic market in 9M 06 compared to 9M05 was the build-up of inventory at MENT during FY 05.  As discussed above, we believe this build-uphas been sold through to end users, and that comparisons of sales of ENTEndoSheaths to MENT will continue to be positive going forward.  The primary reason for the decrease in salesof ENT endoscopes was the sales to MENT of our new TNE endoscopes in 9M 05 thatdid not recur in 9M 06.

 

We further delineateproducts sold to the international ENT market as follows:

 
| **ENT Products**     | ** ** | **9M 06** | ** ** | **9M 05** | ** ** | **Increase  (Decrease)** | ** ** | **Percent** | ** ** |
|----------------------|------------|-----------|------------|-----------|------------|--------------------------|------------|-------------|------------|
| Slide-On EndoSheaths |       | $         | 1501       |      | $          | 1,138                    |       | $           | 363        |   | 32 | % |
| Endoscopes           |       | 608       |       | 394       |       | 214                      |       | 54          | %          |
| Total International  |       | $         | 2,109      |      | $          | 1,532                    |       | $           | 577        |   | 38 | % |

 

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The primary reason forthe increase in sales of ENT SOS to international distributors was higherdemand, especially in Europe.  Inaddition, we established new distributors in the Middle East for our ENT endoscopesand ENT SOS.  The increase in sales ofendoscopes was caused primarily by higher sales in Q3 06 of our new ENT-3000endoscope with portable light source, and higher sales in the three monthsended June 30, 2005 (“Q1 06”) of our ENT-1000, the small diameter ENTendoscope.

 

*MedicalSales –Urology Market*

 

The increase in sales ofproducts to the urology market was primarily due to shipments of our new CST-2000with Slide-On EndoSheath System to MGU, offset partially by lower sales tointernational distributors.  We soldapproximately $867,000 of CST-2000 and Slide-On EndoSheaths to MGU and $92,000to international distributors, compared to approximately $130,000 and $228,000in 9M 05, respectively.

 

*IndustrialSegment*

 

The decrease in sales ofthe industrial segment was due primarily to higher demand in the market forvideo borescopes, compared to our line of fiber borescopes.

 

Gross Profit

 

*Q3 06 Compared to Q3 05*

 

Gross profit was $884,723in Q3 06, an increase of $97,853, compared to gross profit in Q3 05.  Gross profit increased by approximately $54,000in the medical segment, and by approximately $44,000 in the industrialsegment.  Gross profit in the medicalsegment increased due to higher volume of sales of ENT SOS sold to MENT and internationaldistributors.  This increase was partiallyoffset by a write down of approximately $40,000 of inventory, primarily toreflect the excess of the cost over the market value of our Slide-On cystoscopeEndoSheath.  We have completed a new CST Diagnosticconfiguration of this EndoSheath that is less expensive, and we are currentlyshipping this new EndoSheath to MGU.

 

We are in the process ofdeveloping a new EndoSheath concept and automated equipment to manufacture our EndoSheathsat significantly lower manufacturing costs than our current costs.  We have not decided to purchase thisequipment.  If we do purchase it, weexpect it will be in place approximately 6-9 months after the order is placed.

 

In the industrialsegment, the increase in gross profit was due primarily to higher sales volume.

 

*9M 06Compared to 9M 05*

 

Gross profit was $1,989,211in 9M 06, a decrease of $131,062, compared to gross profit in 9M 05.  Gross profit decreased by approximately $250,000in the medical segment and increased by approximately $119,000 in theindustrial segment.  The decrease in themedical segment was due primarily to higher costs for freight charges incurredto transport assets and inventory parts to and from Israel of approximately$108,000, higher costs for depreciation of equipment of approximately $83,000 andcosts incurred for one-time translation of our Instructions For Use tolanguages in new international markets of approximately $71,000.   These cost increases were partially offsetby higher gross profit from the higher volume of sales of approximately$47,000.

 

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The increase in grossprofit in the industrial segment was primarily due to the lower fixed costs forpersonnel in 9M 06.

 

Operating Expenses

 

*Selling,General and Administrative Expenses*

 

*Q3 06 Compared to Q3 05*

 

The decrease in selling,general and administrative (“SG&A”) expenses was due primarily to lowercharges for terminations of employees of approximately $133,000, offset byhigher spending for personnel and outside services totaling approximately$100,000.

 

*9M 06Compared to 9M 05*

 

The increase inSG&A expenses was due primarily to spending related to outside computerservices of approximately $56,000, recruitment fees of approximately $30,000and a charge to reserve for doubtful accounts of approximately $73,000.  Expenses for the promotion of our ENT andurology products are incurred primarily by our exclusive distributors, MENT andMGU.

 

*Researchand Development Expenses*

 

*Q3 06 Compared to Q3 05*

 

The increase in researchand development (“R&D”) expenses was due primarily to additional spendingfor materials and personnel hired to work on developing new products andmanufacturing methods for the medical segment. We expect R&D expenses will continue to be higher in FY 06, comparedto FY 05, as we increase our efforts to develop new products for medicalmarkets, both those that will utilize the technology inherent in ourEndoSheaths, and other products for the medical market.

 

*9M 06Compared to 9M 05*

 

The increase inR&D expenditures was due to the same reasons as noted above.

 

*Stock-basedCompensation Expenses*

 

The increase instock-based compensation was due primarily to the changes required to complywith Section 409A related to non-qualified stock options originallygranted to employees in June 2003.  Asa result of amending the options to comply with 409A, we incurred stock-basedcompensation costs that were approximately $240,000 higher in both Q3 06 and 9M06, than the costs in Q3 05 and 9M 05.  Wealso incurred other stock-based compensation costs during FY 06 and FY 05, dueprimarily to grants in April 2004 and July 2004 of non-qualifiedoptions to purchase 100,000 shares and 50,000 shares, respectively, of ourCommon Stock to an outside consultant. These grants were in accordance with an agreement entered into with thatconsultant in January 2003.  Thevalue of the non-qualified options were determined to be approximately $371,000,using the Black-Scholes option-pricing model, and are being recorded in ourstatements of operations over the vesting period of the options.  We recorded $46,387 and $139,163 of expensein Q3 06 and 9M 06, respectively, related to these non-qualified options, and$62,546 and $123,004 in Q3 05 and 9M 05, respectively.

 

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Operating Income(Loss)

 

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

 
| **Segment** | ** ** | **Q3 06** | ** ** | **Q3 05** | ** ** | **Change** | ** ** | **9M 06** | ** ** | **9M 05** | ** ** | **Change** | ** ** |
|-------------|------------|-----------|------------|-----------|------------|------------|------------|-----------|------------|-----------|------------|------------|------------|
| Medical     |       | $         | (581       | )         | $          | (339       | )          | $         | (242       | )         | $          | (1,929     | )          | $ | (1,009 | ) | $ | (920 | ) |
| Industrial  |       | 21        |       | (27       | )          | 48         |       | (6        | )          | (58       | )          | 52         |       |
| Corporate   |       | (497      | )          | (429      | )          | (68        | )          | (1,121    | )          | (951      | )          | (170       | )          |
| Total       |       | $         | (1,057     | )         | $          | (795       | )          | $         | (262       | )         | $          | (3,056     | )          | $ | (2,018 | ) | $ | (1,038 | ) |

 

In the medical segment, thehigher gross profit was more than offset by higher spending for SG&A andR&D, resulting in a higher loss in Q3 06, compared to Q3 05.  For 9M 06, compared to 9M 05, the lower grossprofit in Q1 06 combined with higher spending for R&D resulted in a higherloss.

 

In the industrialsegment, the higher gross profit was the primary cause for the improvedoperating results in Q3 06, compared to Q3 05. For 9M 06, compared to 9M 05, the higher gross profit more than offset thehigher charge for bad debts, resulting in a lower loss.

 

In the corporate segment,the higher charge for stock-based compensation resulted in higher losses in Q306, compared to Q3 05, and in the 9M 06, compared to 9M 05.

 

Liquidity andCapital Resources

 

At December 31, 2005, our principal sourceof liquidity was working capital of approximately $9.3 million, including $6.9 millionin cash and cash equivalents.

 

In October 2005 we signed a Loan andSecurity Agreement (the “Bank Agreement”) with Citizens Bank of Massachusetts (the“Bank”).  The Bank Agreement provides fora revolving line of credit under which we may borrow up to $250,000 for generalworking capital purposes, including letters of credit and bankers’acceptances.  In addition, the BankAgreement provides an equipment line of credit of up to $750,000 to finance theacquisition of machinery and equipment. Borrowings under this Bank Agreement would bear interest at the primerate of the Bank, and be collateralized by all the assets of the Company.  The Company has an affirmative covenant thatrequires that one-half of our cash and cash equivalents, or a minimum of$2,000,000, be invested in obligations of the bank, or on deposit with the Bank.  The Bank Agreement expires July 31,2006, at which time we will be able to negotiate a renewal.

 

Ourcash and cash equivalents decreased by approximately $2,935,000 in the nine monthsended December 31, 2005, due primarily to cash used for operations ofapproximately $2,825,000 and cash used for investing activities ofapproximately $318,000.  These uses wereoffset by the exercise of stock options by employees and non-employees totalingapproximately $146,000, and the receipt in April 2005 of a subscriptionreceivable from one of the investors in our sale of common shares in February 2005of approximately $56,000, net.  We expectthat our current balance of cash and cash equivalents will be sufficient tofund our operations for the next twelve months.

 

We have incurred lossessince our inception, and losses are expected to continue at least during FY 06.  We have funded the losses principally withthe proceeds from public and private equity financings.  The

 

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private equity financingshave included sales of new common stock to two employees who are alsodirectors, to a hedge fund, to other independent directors and to independentprivate individuals.

 

We expect total spendingfor property and equipment to be approximately $850,000 for FY 06, includingapproximately $400,000 if we place a purchase order for a new automated machine.  This amount could be higher or lower, dependingupon the terms we negotiate for the purchase of the equipment we are designingto manufacture our new low-cost EndoSheath. We expect to obtain long-term financing for this purchase, but there canbe no assurance such financing will be available to us, or available on termsacceptable to us.

 

We conduct our operations in certain leased facilities.  These leases expire on various dates through August 31,2010.  In addition, we have operatingleases for certain office equipment. These leases expire on various dates through April 2009.  The following chart summarizes ourcontractual obligations as of December 31, 2005.

 
| **Contractual Obligation** | ** ** | **Total** | ** ** | **Due within 1 year** | ** ** | **Due in 1-3 years** | ** ** |
|----------------------------|------------|-----------|------------|-----------------------|------------|----------------------|------------|
| Operating leases           |       | $         | 1,125,586  |                  | $          | 389,447              |       | $ | 736,139 |   |
| Capital lease              |       | 37,027    |       | 25,912                |       | 11,115               |       |
|                            |            |           |            |                       |            |                      |            |  |  |  |

 

We have no off-balancesheet arrangements that have, or are reasonably likely to have, a current orfuture effect on our financial condition, changes in financial condition,revenues or expenses, results of operations, liquidity, capital expenditures orcapital resources.

 

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## **Item3.  QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK**

## ** **

In the normal course ofbusiness, we are subject to the risks associated with fluctuations in interestrates and changes in foreign currency exchange rates.

 

#### *Interest and Market Risk*

#### * *

We currently investour excess cash in a money market account at our bank, and in commercial paperrated A1/P1.  We have not used derivativefinancial instruments in our investment portfolio.  We attempt to limit our exposure to interestrate and credit risk by placing our investments with high-quality financialinstitutions and have established investment guidelines relative todiversification and maturities designed to maintain safety and liquidity.

 

Investments in bothfixed-rate and floating-rate interest earning instruments carry a degree ofinterest rate risk.  Fixed-ratesecurities may have their fair market value adversely impacted due to a rise ininterest rates, while floating-rate securities may produce less income thanexpected if interest rates decline.  Duein part to these factors, our future investment income may fall short ofexpectations due to changes in interest rates, or we may suffer losses inprincipal if forced to sell securities which have seen a decline in marketvalue due to changes in interest rates.

 

#### *Foreign Currency Exchange*

#### * *

We face exposure, due topurchases of raw materials from Japanese suppliers, to adverse movements in thevalue of the Japanese Yen.  This exposuremay change over time, and could have a materially adverse effect on our financialresults.  We may attempt to limit thisexposure by purchasing forward contracts, as required.  Most of our Japanese Yen liabilities aresettled within 90 days of receipt of materials. At December 31, 2005, our liabilities relating to Japanese Yen wereapproximately $56,000.

 

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## **Item4.  CONTROLS AND PROCEDURES**

## ** **

*a)**            Evaluationof Disclosure Controls and Procedures.*

 

Based on an evaluation ofour disclosure controls and procedures (as defined in Rules 13a-14(c) and15d-14(c) under the Securities Exchange Act of 1934), the chief executiveofficer and chief financial officer have concluded that our disclosure controlsand procedures as of the end of the three months ended December 31, 2005,are effective.

 

*b)**            Changesin Internal Controls Over Financial Reporting.*

 

There were nochanges in our internal controls over financial reporting that occurred duringthe fiscal quarter ended December 31, 2005 that have materially affected,or are reasonable likely to materially affect, our internal controls overfinancial reporting.

 

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**PART II- OTHER INFORMATION**

 

**Item5.  Other Information**

 

In October 2005, wesigned a Loan and Security Agreement with Citizens Bank of Massachusetts.  See the description of the Loan and SecurityAgreement under Item 2 above, which is incorporated by reference herein.

 

**Item 6.  List of Exhibits**

 
| ** ** | **Exhibits** | ** **                                                                                                                                                                           |
|------------|--------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |         |                                                                                                                                                                                 |
|       | 10.1         | Termination and  Settlement Agreement, dated October 2, 2005 by and between the  Registrant and Three BY Ltd.                                                                   |
|       |         |                                                                                                                                                                                 |
|       | 10.2         | Loan and  Security Agreement, dated October 31, 2005 between the Registrant and  Citizens Bank of Massachusetts.                                                                |
|       |         |                                                                                                                                                                                 |
|       | 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. |

 

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##### **SIGNATURES**

##### ** **

Pursuant to therequirements of the Securities Exchange Act of 1934, the Registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 
| VISION-SCIENCES, INC.        |
|------------------------------|
|                         |
|                         |
| Date: February 14, 2006 | /s/ Ron Hadani |   |
|                         | Ron Hadani |
|                         | President, CEO (Duly Authorized Officer) |
|                         |   |
|                         |   |
| Date: February 14, 2006 | /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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