**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 June 30,2005**

 

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

 

Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirement for the past 90 days.

 

Yes ý    No  o

 

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

 

Yes o    No  ý

 

                Indicatethe number of shares outstanding of each of the issuer’s classes of commonstock, as of July 31, 2005.

 

| **Common  Stock, par value of $.01** | ** ** | **35,092,377**     | ** ** |
|--------------------------------------|------------|--------------------|------------|
| (Title of Class)                     |       | (Number of Shares) |       |

 

 

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**VISION-SCIENCES, INC.TABLE OF CONTENTS**

 
|     |                          |                                                                                        | **Page** |
|----------|-------------------------------|---------------------------------------------------------------------------------------------|----------|
| Part I.  | Financial  Information        |                                                                                        |     |
|     |                          |                                                                                        |     |   |
|     | Item 1.  Financial Statements |                                                                                        |     |
|     |                          |                                                                                        |     |   |
|     |                          | Consolidated  Balance Sheets                                                                |     | 3 |
|     |                          |                                                                                        |     |   |
|     |                          | Consolidated  Statements of Operations                                                      |     | 4 |
|     |                          |                                                                                        |     |   |
|     |                          | Consolidated  Statement of Stockholders’ Equity and Comprehensive Loss                 |     | 5 |
|     |                          |                                                                                        |     |   |
|     |                          | Consolidated  Statements of Cash Flows                                                      |     | 6 |
|     |                          |                                                                                        |     |   |
|     |                          | Notes  to Consolidated Financial Statements                                                 |     | 7 |
|     |                          |                                                                                        |     |   |
|     | Item 2.                  | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |     | 14 |
|     |                          |                                                                                        |     |   |
|     | Item 3.                       | Quantitative  and Qualitative Disclosures about Market Risk                                 |     | 25 |
|     |                          |                                                                                        |     |   |
|     | Item  4.                      | Controls  and Procedures                                                               |     | 26 |
|     |                          |                                                                                        |     |   |
| Part II. | Other  Information            |                                                                                        |     |
|     |                          |                                                                                        |     |   |
|     | Item 6.                       | Exhibits                                                                               |     | 27 |
|     |                          |                                                                                        |     |
|     | Signatures                    |                                                                                        | 28       |
|     |                          |                                                                                        |     |   |
|     | Exhibits                      |                                                                                        |     |

 

2

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**PART I -FINANCIAL INFORMATION**

** **

**Item 1: FINANCIAL STATEMENTS**

 

**VISION-SCIENCES, INC. ANDSUBSIDIARIES**

**CONSOLIDATED BALANCE SHEETS**

**(Unaudited)**

 
| ** **                                                                                                                                  | ** ** | **June 30,  2005** | ** ** | **March  31,  2005** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|----------------------|------------|
|                                                                                                                                        |       |               |       |                 |       |
| ASSETS                                                                                                                                      |       |               |       |                 |       |
| Current Assets:                                                                                                                             |       |               |       |                 |       |
| Cash and cash  equivalents                                                                                                                  |       | $                  | 8,965,179  |                 | $          | 9,868,586 |   |
| Accounts  receivable, net of allowance for doubtful accounts of $93,133 and $70,097,  respectively                                          |       | 1,696,079          |       | 1,662,486            |       |
| Inventories                                                                                                                                 |       | 2,240,454          |       | 1,876,824            |       |
| Prepaid expenses  and deposits                                                                                                              |       | 46,494             |       | 61,964               |       |
| Total current  assets                                                                                                                       |       | 12,948,206         |       | 13,469,860           |       |
|                                                                                                                                        |       |               |       |                 |       |
| Property and  Equipment, at cost:                                                                                                           |       |               |       |                 |       |
| Machinery and  equipment                                                                                                                    |       | 4,534,849          |       | 4,427,047            |       |
| Furniture and  fixtures                                                                                                                     |       | 242,406            |       | 242,406              |       |
| Leasehold  improvements                                                                                                                     |       | 576,030            |       | 573,780              |       |
|                                                                                                                                        |       | 5,353,285          |       | 5,243,233            |       |
| Less-Accumulated  depreciation and amortization                                                                                             |       | 4,142,711          |       | 4,040,060            |       |
|                                                                                                                                        |       | 1,210,574          |       | 1,203,173            |       |
|                                                                                                                                        |       |               |       |                 |       |
| Other assets,  net of accumulated amortization of $55,416 and $53,815, respectively                                                         |       | 73,216             |       | 74,816               |       |
| Total assets                                                                                                                                |       | $                  | 14,231,996 |                 | $          | 14,747,849 |   |
|                                                                                                                                        |       |               |       |                 |       |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                                   |       |               |       |                 |       |
| Current  Liabilities:                                                                                                                       |       |               |       |                 |       |
| Acceptances  payable to a bank                                                                                                              |       | $                  | 59,021     |                 | $          | — |   |
| Current portion  of note payable                                                                                                            |       | 24,913             |       | 24,431               |       |
| Accounts payable                                                                                                                            |       | 819,624            |       | 637,408              |       |
| Accrued expenses                                                                                                                            |       | 1,050,580          |       | 1,213,577            |       |
| Total current  liabilities                                                                                                                  |       | 1,954,138          |       | 1,875,416            |       |
|                                                                                                                                        |       |               |       |                 |       |
| Long-term  portion of note payable                                                                                                          |       | 24,560             |       | 31,089               |       |
|                                                                                                                                        |       |               |       |                 |       |
| Stockholders’ Equity:                                                                                                                  |       |               |       |                 |       |
| Common stock,  $.01 par value—                                                                                                         |       |               |       |                 |       |
| Authorized—50,000,000  shares  Issued and outstanding—35,084,877 shares at June 30, 2005 and 34,998,877  shares at March 31, 2005 |       | 350,848            |       | 349,988              |       |
| Additional  paid-in capital                                                                                                                 |       | 75,229,740         |       | 74,987,548           |       |
| Accumulated  deficit                                                                                                                        |       | (63,327,290        | )          | (62,496,192          | )          |
| Total  stockholders’ equity                                                                                                            |       | 12,253,298         |       | 12,841,344           |       |
| Total  liabilities and stockholders’ equity                                                                                            |       | $                  | 14,231,996 |                 | $          | 14,747,849 |   |

 

See accompanyingnotes to consolidated financial statements.

 

3

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

** **
| ** **                                                            | ** ** | **Three Months Ended  June 30,** | ** ** |
|-----------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                            | ** ** | **2005**                         | ** ** | **2004** | ** ** |
| Net sales                                                             |       | $                                | 2,532,958  |   | $ | 2,776,780 |   |
| Cost of sales                                                         |       | 1,922,818                        |       | 1,694,216 |   |
|                                                                  |       |                             |       |   |   |
| Gross profit                                                          |       | 610,140                          |       | 1,082,564 |   |
|                                                                  |       |                             |       |   |   |
| Selling, general  and administrative expenses (1)                     |       | 945,369                          |       | 996,435 |   |
| Research and  development expenses(1)                                 |       | 497,064                          |       | 340,194 |   |
| Stock-based  compensation                                             |       | 49,684                           |       | 33,526 |   |
| Loss from  operations                                                 |       | (881,977                         | )          | (287,591 | ) |
|                                                                  |       |                             |       |   |   |
| Interest income                                                       |       | 45,786                           |       | 8,685 |   |
| Interest expense                                                      |       | (967                             | )          | (1,403 | ) |
| Other income,  net                                                    |       | 6,060                            |       | 3,658 |   |
|                                                                  |       |                             |       |   |   |
| Net loss                                                              |       | $                                | (831,098   | ) | $ | (276,651 | ) |
|                                                                  |       |                             |       |   |   |
| Basic and  diluted net loss per common share                          |       | $                                | (0.02      | ) | $ | (0.01 | ) |
|                                                                  |       |                             |       |   |   |
| Shares used in  computing basic and diluted net loss per common share |       | 35,047,919                       |       | 30,835,192 |   |

 

----

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

 
| Research and  development expenses            |   | $      | 109    |   | $      | 109    |   |
|-----------------------------------------------|--------|--------|--------|--------|--------|--------|--------|
| Selling, general  and administrative expenses |   | 49,575 |   | 33,417 |   |
| Total                                         |   | $      | 49,684 |   | $      | 33,526 |   |

 

See accompanyingnotes 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                                           |       | 86,000                 |       | 860                        |       | 99,915                           |       | —                   |       | 100,775                            |        |   |   |
| Receipt of  subscription receivable                                       |       |                   |       |                       |       | 92,593                           |       |                     |       | 92,593                             |        |   |   |
| Compensation  expense related to non-employee non-qualified stock options |       |                   |       |                       |       | 46,387                           |       | —                   |       | 46,387                             |        |   |   |
| Compensation  expense related to employee non-qualified stock options     |       |                   |       |                       |       | 3,297                            |       |                     |       | 3,297                              |        |   |   |
| Net loss                                                                  |       | —                 |       | —                     |       | —                           |       | (831,098                 | )          | (831,098                           | )           | $ | (831,098 | ) |
|                                                                      |       |                   |       |                       |       |                             |       |                     |       |                               |        |   |   |
| Total comprehensive  loss                                                 |       |                   |       |                       |       |                             |       |                     |       |                               |        | $ | (831,098 | ) |
|                                                                      |       |                   |       |                       |       |                             |       |                     |       |                               |        |   |   |
| Balance June 30,  2005                                                    |       | 35,084,877             |       | $                          | 350,848    |                             | $          | 75,229,740               |       | $                                  | (63,327,290 | ) | $ | 12,253,298 |   |   |   |

 

See accompanyingnotes to consolidated financial statements.

 

5

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

 
| ** **                                                                    | ** ** | **Three Months Ended  June 30, 2005** | ** ** | **Three Months Ended  June 30, 2004** | ** ** |
|-------------------------------------------------------------------------------|------------|---------------------------------------|------------|---------------------------------------|------------|
| Cash flows from operating activities:                                         | ** ** | ** **                            | ** ** | ** **                            | ** ** |
| Net loss                                                                      |       | $                                     | (831,098   | )                                     | $          | (276,651 | ) |
| Adjustments to  reconcile net loss to net cash used for operating activities: |       |                                  |       |                                  |       |
| Depreciation and  amortization                                                |       | 104,251                               |       | 56,862                                |       |
| Stock  compensation for non-qualified options                                 |       | 49,684                                |       | 33,526                                |       |
| Changes in  assets and liabilities:                                           |       |                                  |       |                                  |       |
| Accounts receivable                                                           |       | (33,593                               | )          | 266,494                               |       |
| Inventories                                                                   |       | (363,630                              | )          | (288,985                              | )          |
| Prepaid expenses  and deposits                                                |       | 15,470                                |       | (19,279                               | )          |
| Accounts payable                                                              |       | 182,216                               |       | (59,783                               | )          |
| Accrued expenses                                                              |       | (162,997                              | )          | (15,596                               | )          |
|                                                                          |       |                                  |       |                                  |       |
| Net cash used  for operating activities                                       |       | (1,039,697                            | )          | (303,412                              | )          |
|                                                                          |       |                                  |       |                                  |       |
| Cash flows used  for investing activities                                     |       |                                  |       |                                  |       |
| Purchase of  property and equipment, net                                      |       | (110,052                              | )          | (154,392                              | )          |
|                                                                          |       |                                  |       |                                  |       |
| Net cash used  for investing activities                                       |       | (110,052                              | )          | (154,392                              | )          |
|                                                                          |       |                                  |       |                                  |       |
| Cash flows  provided by (used for) financing activities:                      |       |                                  |       |                                  |       |
| Payments on note  payable for computer equipment                              |       | (6,047                                | )          | (4,213                                | )          |
| Proceeds from  acceptances payable to a bank                                  |       | 59,021                                |       | 18,481                                |       |
| Proceeds from  the sale of common stock, net                                  |       | 92,593                                |       | —                                |       |
| Exercise of  stock options, net                                               |       | 100,775                               |       | 259,179                               |       |
| Net cash  provided by financing activities                                    |       | 246,342                               |       | 273,447                               |       |
| Net decrease in  cash and cash equivalents                                    |       | (903,407                              | )          | (184,357                              | )          |
| Cash and cash  equivalents, beginning of period                               |       | 9,868,586                             |       | 2,714,941                             |       |
| Cash and cash  equivalents, end of period                                     |       | $                                     | 8,965,179  |                                  | $          | 2,530,584 |   |
|                                                                          |       |                                  |       |                                  |       |
| Supplemental  Disclosure of Cash Flow Information:                            |       |                                  |       |                                  |       |
| Cash paid during  the period for interest                                     |       | $                                     | 967        |                                  | $          | 1,403 |   |
|                                                                          |       |                                  |       |                                  |       |
| Supplemental  Disclosure of Non-cash Items from Financing Activities:         |       |                                  |       |                                  |       |
|                                                                          |       |                                  |       |                                  |       |
| Fair market  value of non-qualified options granted in the period             |       | $                                     | —     |                                  | $          | 241,832 |   |

 

See accompanyingnotes to consolidated financial statements.

 

6

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**VISION-SCIENCES, INC. ANDSUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

**(Unaudited)**

 

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

 

The consolidated financial statements included hereinhave been prepared by Vision-Sciences, Inc. and subsidiaries (the “Company”) inaccordance with accounting principles generally accepted in the United Statesof America, without audit, pursuant to the rules and regulations of theSecurities and Exchange Commission and include, in the opinion of management,all adjustments (consisting only of normal and recurring adjustments) that theCompany considers necessary for a fair presentation of such information.  Certain information and footnote disclosuresnormally included in financial statements have been condensed or omittedpursuant to such rules and regulations. The Company believes, however, that its disclosures are adequate to makethe information presented not misleading. These consolidated financial statements should be read in conjunctionwith the audited consolidated financial statements and notes thereto includedin the Company’s latest annual report to stockholders.  The results for the interim periods presentedare not necessarily indicative of results to be expected for the full fiscalyear.

 

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

 

The accompanying consolidated financial statements reflectthe application of certain accounting policies described below:

 

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

 

b**.****            ***Cash Equivalents*: Cash equivalents consist of a money marketaccount at a bank.  Cash equivalents arecarried at 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:

 

 
| ** **      | ** ** | **June 30,  2005** | ** ** | **March  31,  2005** | ** ** |
|-----------------|------------|--------------------|------------|----------------------|------------|
|            |       | ** **         | ** ** | **(audited)**        |       |
| Raw materials   |       | $                  | 1,437,789  |                 | $          | 1,166,946 |   |
| Work-in-process |       | 279,025            |       | 253,449              |       |
| Finished goods  |       | 523,640            |       | 456,429              |       |
|            |       | $                  | 2,240,454  |                 | $          | 1,876,824 |   |
|                 |            |                    |            |                      |            |  |  |  |

 

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

 

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:

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

 

Leasehold improvements are amortized over the shorterof their estimated useful lives or the 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 arrangement exists,(2) delivery has occurred or services have been rendered, (3) the price isfixed or determinable, (4) collectibility is reasonably assured and (5) the fairvalue of undelivered elements, if any, exists. To date the Company has not entered into any multiple elementarrangements.  The Company recognizesrevenue when title passes to the customer, generally upon shipment of productsF.O.B. shipping point.  Since September2004, the Company’s medical segment has distributed all of its products for theEar-Nose-Throat (“ENT”) market in the U.S.A. and Canada through an agreement(the “Medtronic Agreement”) with Medtronic Xomed, Inc. (“Medtronic Xomed”).  The initial term of the Medtronic Agreementwas three years, renewable thereafter annually, unless terminated by eitherparty.

 

During the fiscalyear ended March 31, 2005 (“FY 05”), the Company and Medtronic Xomed modifiedthe Medtronic Agreement to provide for a rebate to Medtronic Xomed for sales ofENT EndoSheaths to new customers who commit to large purchases.  The rebate program is designed to run for oneyear to September 30, 2005.  The Companyaccounts for this modification under Emerging Issues Task Force (“EITF”) 01-9, *Accounting for Consideration Given by a Vendor to a Customer (Includinga Reseller of the Vendor’s Products)*.  As of June 30, 2005, the Company has providedfor rebates of approximately $51,000.

 

Since December2004, the Company’s medical segment has distributed all of its products for theurology market in the U.S.A. and Canada through an agreement (the “MGUAgreement”) with Medtronic USA, Inc. (“MGU”). The term of the MGU Agreement is through March 31, 2006, renewable forsuccessive one-year periods unless either party notifies the other party inwriting at least 90 days prior to the end of any term that it does not want torenew.

 

8

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f.              *Revenue Recognition*: *(continued):* Neitherthe Medtronic Agreement nor the MGU Agreement provide for any contingencies,nor provide any terms related to product acceptance or warranty that aredifferent from the normal terms provided by the Company 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 SFASNo. 109, deferred tax assets or liabilities are computed based upon thedifferences between the financial statement and income tax bases of assets andliabilities as measured by the enacted tax rates.

 

The Company has recordeda valuation allowance equal to its net deferred tax asset due to theuncertainty of realizing the benefit of this asset.

 

i               *Accounting for Options Issued to Non-employees:*The Companyaccounts for non-qualified stock option agreements issued to non-employees asequity instruments, in accordance with the provisions of EITF 96-18.  In the three months ended June 30, 2005, theCompany did not grant any non-qualified options to purchase shares of theCompany’s Common Stock.  During thefiscal year ended March 31, 2005, the Company granted options to purchase 150,000shares of the Company’s Common Stock to non-employees.  The fair value of these options measured atthe option grant dates was approximately $371,000, determined using theBlack-Scholes option-pricing model, and is being recorded as an expense overthe vesting period.  The assumptions usedin the Black-Scholes option-pricing model by the Company 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         |

 

During the three monthsended June 30, 2005 and 2004, the Company recognized $46,387 and $30,229,respectively, of expense related to such options.

 

9

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j.              *Employee Stock-based CompensationArrangements:*The Company accounts for its employeestock-based compensation arrangements using the intrinsic value method underthe provisions of Accounting Principles Board (“APB”) Opinion No. 25, *Accounting for Stock Issued to Employees*, and FinancialInterpretation No. (“FIN”) 44.  TheCompany does not recognize stock-based employee compensation cost when theoptions granted have an exercise price equal to, or greater than, the marketvalue of the underlying common stock on the date of the grant.  The Company does recognize stock-basedemployee compensation cost when the options granted have an exercise price lessthan the market value of the underlying common stock on the date of the grant.

 

In June 2003, theCompany granted options to purchase 1,295,000 shares of common stock to itsemployees at an exercise price of $1.04 per share.  The fair market value of the common stock onthe date of grant was $1.09 per share. As a result, the Company has recognized compensation expense for thedifference between the fair market value and the option price over the life ofthe options.  In each of the three monthsended June 30, 2005, and 2004, the Company recognized $3,297 of expense relatedto these options as stock-based compensation in the consolidated statements ofoperations.

 

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

 
| ** **                                            | ** ** | **Three Months Ended  June 30,** | ** ** |
|-------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                            | ** ** | **2005**                         | ** ** | **2004** | ** ** |
| Net loss – as  reported                          |       | $                                | (831,098   | ) | $ | (276,651 | ) |
| Stock-based  employee compensation – as reported |       | 3,297                            |       | 3,297 |   |
| Pro forma  stock-based employee compensation          |       | (119,170                         | )          | (94,500 | ) |
| Net loss - pro  forma                                 |       | $                                | (946,971   | ) | $ | (367,854 | ) |
|                                                  |       |                             |       |   |   |
| Net loss per  share – as reported                |       | $                                | (.02       | ) | $ | (0.01 | ) |
| Stock-based  employee compensation – as reported |       | —                           |       | — |   |
| Pro forma  stock-based employee compensation          |       | (.01                             | )          | — |   |
| Net loss per  share - pro forma                       |       | $                                | (.03       | ) | $ | (0.01 | ) |

 

10

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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 theguidance in ARB No. 43, Chapter 4, *Inventory Pricing*,to clarify the accounting for abnormal amounts of idle facility expense,freight, handling costs and spoilage. This statement requires that those items be recognized as current periodcharges regardless of whether they meet the criterion of “so abnormal” whichwas the criterion specified in ARB No. 43. In addition, this Statement requires that allocation of fixed productionoverheads to the cost of production be based on normal capacity of theproduction facilities.  Thispronouncement is effective for fiscal years beginning after June 15, 2005.  The Company has not yet assessed the impactof adopting this new standard.

 

In December 2004, the FASB issued SFAS No. 123(revised 2004), *Share-Based Payment*.  SFAS 123R is a revision of SFAS No. 123, *Accounting for Stock-Based Compensation* and supersedes APBNo. 25, *Accounting for Stock Issued to Employees*,and its related implementation guidance. SFAS 123R requires all share-based payments to employees, includinggrants of employee stock options, to be recognized in the financial statementsbased on their fair values beginning with the first interim or annual periodafter June 15, 2005, with early adoption encouraged.  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 endingMarch 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 forcompensation costs and the transition method to be used at date of adoption.The transition methods include prospective and retrospective adoption options.

 

Under the retroactive option, prior periods may berestated either as of the beginning of the year of adoption or for all periodspresented.  The prospective methodrequires that compensation expense be recorded for all unvested stock optionsand restricted stock at the beginning of the first quarter of adoption of SFAS123R, while the retroactive method would record compensation expense for allunvested stock options and restricted stock beginning with the first periodrestated.  The Company is evaluating therequirements of SFAS 123R and expects that the adoption of SFAS 123R may have amaterial impact on its consolidated results of operations and earnings pershare.  The Company has not yetdetermined the method of adoption or the effect of adopting SFAS 123R, and ithas not determined whether the adoption will result in amounts that are similarto the current pro forma disclosures under SFAS 123.

 

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

 

In June 2003, the Companyentered into a Contract Manufacturing Agreement, a Loan Agreement and a PledgeAgreement (collectively, the “3BY Agreements”) with Three BY Ltd., an Israelicompany (“3BY”).  The 3BY Agreementsprovide for, among other things, the manufacture of certain of the Company’sproducts by 3BY, and a loan of up to $267,500 by the Company to 3BY for thepurchase and installation of certain manufacturing equipment by 3BY, at 3BY’sfacility, to be used to manufacture certain of the Company’s products.  As of December 31, 2003, the Company hadadvanced the complete loan.  3BY hascompleted the purchase and installation of the manufacturing equipment, and theCompany began receiving commercial production from 3BY in the three monthsending September 30, 2004.  On October 1,2004, according to terms in the Loan Agreement, 3BY and the Company agreed thatthe Company would take title to the manufacturing equipment, in lieu of 3BYretaining title and paying back the advance.

 

In May 2005, the Companydecided to bring the manufacturing of these products back to its Natick, MAplant, due to the inability to exert sufficient control over the manufacturingprocesses to have the confidence level necessary for its product quality.  In addition, the costs savings anticipatedhave not been attained.  The Companyintends to ship the equipment at 3BY to its plant in Natick, MA, after thedetails and time schedules of the transfer have been finalized.  To date, the Company does not believe theseassets are impaired based upon their intended use.  However, depending upon the demand for theCompany’s products that utilize this equipment, and the Company’s ability toreconfigure the equipment to manufacture other products, the Company may incura charge for impairment in the future related to this equipment which is valuedat approximately $350,000 at June 30, 2005.

 

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

 

The Company has threereportable segments – medical, industrial and corporate.  The medical segment designs, manufactures andsells EndoSheaths and sells endoscopes to users in the health careindustry.  The industrial segmentdesigns, manufactures and sells borescopes to a variety of users, primarily inthe aircraft engine manufacturing and aircraft engine maintenanceindustries.  In addition, the industrialsegment manufactures and repairs endoscopes for the medical segment.  The corporate segment consists of certainadministrative expenses applicable to the Company as a whole and the managementoversight of the Company’s investment in Vision-Sciences, Ltd. (the Company’sIsraeli subsidiary).

 

All segments follow the accounting policies describedin the summary of significant accounting policies.  The Company evaluates segment performancebased upon operating income. Identifiable assets are those used directly in the operations of eachsegment.  Corporate assets include cash,marketable securities and the assets of Vision-Sciences, Ltd.  Data regarding management’s view of the Company’ssegments are provided in the following tables.

 

 
| **Three months ended June 30,**    | ** ** | **Medical** | ** ** | **Industrial** | ** ** | **Corporate** | ** ** | **Adjustments** | ** ** | **Total**  | ** ** |
|------------------------------------|------------|-------------|------------|----------------|------------|---------------|------------|-----------------|------------|------------|------------|
| **2005**                           |       |        |       |           |       |          |       |            |       |       |       |
| Sales to  external customers       |       | $           | 1,909,329  |           | $          | 623,629       |       | $               | —     |       | $          | — |   | $ | 2,532,958 |   |
| Intersegment  sales                |       | —      |       | 828,791        |       | —        |       | (828,791        | )          | —     |       |
| Operating income  (loss)           |       | (612,523    | )          | (14,042        | )          | (255,412      | )          | —          |       | (881,977   | )          |
| Interest income  (expense), net    |       | —      |       | —         |       | 44,819        |       | —          |       | 44,819     |       |
| Depreciation and  amortization     |       | 89,443      |       | 14,808         |       | —        |       | —          |       | 104,251    |       |
| Other significant  non-cash items: |       |        |       |           |       |          |       |            |       |       |       |
| Stock-based  compensation          |       | 46,575      |       | 62             |       | 3,047         |       | —          |       | 49,684     |       |
| Expenditures for  fixed assets     |       | 102,227     |       | 7,825          |       | —        |       | —          |       | 110,052    |       |
| Total assets                       |       | 3,474,384   |       | 1,786,976      |       | 9,051,134     |       | (80,498         | )          | 14,231,996 |       |
|                               |       |        |       |           |       |          |       |            |       |       |       |
| **2004**                           |       |        |       |           |       |          |       |            |       |       |       |
| Sales to  external customers       |       | $           | 1,977,329  |           | $          | 799,451       |       | $               | —     |       | $          | — |   | $ | 2,776,780 |   |
| Intersegment  sales                |       | —      |       | 646,961        |       | —        |       | (646,961        | )          | —     |       |
| Operating income  (loss)           |       | 10,072      |       | 20,232         |       | (317,895      | )          | —          |       | (287,591   | )          |
| Interest income  (expense), net    |       | —      |       | —         |       | 7,282         |       | —          |       | 7,282      |       |
| Depreciation and  amortization     |       | 44,383      |       | 10,973         |       | 1,506         |       | —          |       | 56,862     |       |
| Other  significant non-cash items: |       |        |       |           |       |          |       |            |       |       |       |
| Stock-based  compensation          |       | 187         |       | 63             |       | 33,276        |       | —          |       | 33,526     |       |
| Expenditures for  fixed assets     |       | 149,733     |       | 4,659          |       | —        |       | —          |       | 154,392    |       |
| Total assets                       |       | 2,786,790   |       | 1,310,372      |       | 2,621,052     |       | (34,697         | )          | 6,683,517  |       |
|                                    |            |             |            |                |            |               |            |                 |            |            |            |  |  |  |  |  |  |  |  |  |  |

 

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

 

**ExecutiveSummary**

 

This Quarterly Report on Form 10-Q containsforward-looking statements within the meaning of The Private SecuritiesLitigation Reform Act of 1995.  Examplesof forward-looking statements include statements about expectations aboutfuture financial results, future products and future sales of new and existingproducts, future expenditures, and capital resources to meet anticipatedrequirements.  Without limiting theforegoing, the words “believes”, “anticipates”, “plans”, “expects”, and similarexpressions are intended to identify forward-looking statements.  These forward-looking statements involverisks and uncertainties, and our actual results may differ significantly fromthose discussed in the forward-looking statements. Factors that might causesuch a difference include, but are not limited to, the availability of capitalresources, the availability of third-party reimbursement, governmentregulation, the availability of supplies, competition, technologicaldifficulties, the continuation of our contracts with Medtronic Xomed and MGU, generaleconomic conditions and other risks detailed in our most recent Annual Reporton Form 10-K and any subsequent periodic filings made with the Securities andExchange Commission.  We do not undertakean obligation to update our forward-looking statements to reflect future eventsor circumstances.

 

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

 

#### *Medical Segment*

 

The medical segment supplies flexible endoscopes and disposable Slide-OnTMEndoSheath® Systems (“EndoSheaths”) to the ENT, gastrointestinal (“GI”),urology and pulmonary markets. Health-care providers use EndoSheaths to cover the insertion tube offlexible endoscopes, such as ENT endoscopes, Trans-Nasal Esophagoscopes (“TNE”),sigmoidoscopes, cystoscopes and bronchoscopes. We have designed the EndoSheaths to allow the health-care providers toprocess patients economically by permitting the providers to minimizereprocessing the endoscopes between procedures. In addition, the EndoSheaths ensure a sterile insertion tube for eachpatient procedure.

 

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

 

#### *Sales Distribution*

 

Since September 19, 2003, we have beendistributing all of our products for the ENT market in the U.S.A. and Canadathrough Medtronic Xomed as part of the Medtronic Agreement. The initial term ofthe Medtronic Agreement is three years. Thereafter, the Medtronic Agreement is automatically renewed forsuccessive one-year periods, unless terminated by either party upon advancewritten notice.  Under the MedtronicAgreement, we have granted Medtronic Xomed exclusive distribution rights in theU.S.A. and Canada to market and sell our ENT and TNE EndoSheaths and endoscopesto ENT practitioners.  Medtronic Xomedfulfilled certain minimum purchase requirements for the initial twelve-monthperiod of the term.  The MedtronicAgreement resulted in an increase in sales of our ENT EndoSheaths and ENTendoscopes due to the quantities of endoscopes and EndoSheaths purchased byMedtronic Xomed in the initial twelve-month period.  In the second year (“Year 2”) of theMedtronic Agreement, Medtronic

 

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purchased fewer units of ENT endoscopes andENT EndoSheaths than in the initial period, due to the build up of inventorythat resulted from the purchases in the initial period.  During Year 2, we and Medtronic Xomed began arebate program, whereby we agreed to pay Medtronic a cash rebate for ENTEndoSheaths they sold to new users who committed to a large annual purchase. Asof June 30, 2005, we recorded a reserve of approximately $51,000 for the rebateprogram.  As of June 30, 2005, MedtronicXomed had approximately 2.0 months of inventory of ENT EndoSheaths onhand.  We expect in the fiscal yearending March 31, 2006 (“FY 06”) that Medtronic Xomed will begin to purchase ENTEndoSheaths at an annualized rate of approximately 140,000 beginning in oursecond fiscal quarter ending September 30, 2005.

 

In addition, in December 2004, we signed theMGU Agreement with MGU, the gastro-urology division of Medtronic, Inc.,granting MGU exclusive rights to distribute our new cystoscope with Slide-OnEndoSheath System to urologists in the U.S.A. and Canada.  The term of the MGU Agreement is throughMarch 31, 2006, renewable for successive one-year periods unless either partynotifies the other party in writing at least 90 days prior to the end of anyterm that it does not want to renew.  Thetotal purchase commitment for cystoscopes and Slide-On EndoSheaths is$1,965,000, of which $353,500 was to be delivered in the fiscal year endedMarch 31, 2005 (“FY 05”), and the remainder in FY 06.  There can be no assurance that MGU willpurchase the total commitment by March 31, 2006.

 

We believe the marketing and salescapabilities of Medtronic Xomed and MGU have facilitated and will continue tofacilitate the introduction of new products to the ENT and urology markets byallowing quicker market acceptance of these products than if we marketed themourselves.  As a result of theseagreements, the success of our ENT and urology product lines is substantiallydependent upon the success of the marketing and sales activities of MedtronicXomed 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*

 

In the fiscal year ended March 31, 2004 (“FY04”) we decided we could reduce manufacturing costs by sub-contracting themanufacture of our EndoSheaths to a company in Israel.  We spent much of FY 05 executing a transitionplan to that end.  However, in May 2005,we realized that the transition was not going to be as successful as we hadplanned, due to a variety of issues surrounding quality, consistency ofpersonnel and cost savings.  As a result,we have decided to bring the manufacture of these products back to our Natickfacility, and expect that to be completed during FY 06, after the details andtime schedules of the transfer have been finalized.  Also during FY 06, we plan to implementreductions in the cost of materials and labor across our endoscope andEndoSheath product lines by examining and updating our material costs and laborprocesses.  In addition, we have begun adevelopment project that we expect will result in automating many of theprocesses performed in the manufacture of EndoSheaths.  Our plan is to have this machinery in placeby the beginning of the fiscal year ending March 31, 2007 (“FY 07”).

 

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#### *New Products*

 

In May 2005, we received clearance from theFDA to market our new ENT-3000 portable endoscope with battery powered LEDlight source.  During FY 06, our productdevelopment plans include a feasibility model of a new Trans-Esophageal Echobased cardioversion product to treat atrial fibrillation, and a thoracicsurgery flexible endoscope with three-dimensional imaging.  We also are continuing our design efforts fora new low-cost EndoSheath concept.  Inaddition, we are designing a new family of smaller sized “D-shaped” proprietaryendoscopes for use with our EndoSheaths that incorporate channels, and a new familyof videoscopes with a distal tip CCD based camera.  We also plan to investigate other potentialproducts for the gastrointestinal and bariatric surgery markets.

 

#### *Industrial Segment*

 

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

 

#### *Corporate Segment*

 

The corporate segment consists of certain administrative and businessdevelopment activities applicable to the Company as a whole.

 

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Critical Accounting Policies and Estimates

 

This discussionand analysis of our financial condition and results of operations is based uponour Consolidated Financial Statements, which have been prepared in accordancewith accounting 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:

 

### *RevenueRecognition*

 

We recognize revenue in accordance with SEC Staff Accounting BulletinNo. 104, *Revenue Recognition in Financial Statements*andEITF 00-21, *Revenue Arrangements with Multiple Deliverables.*These pronouncements require that five basic criteria must be met beforerevenue can be recognized: (1) persuasive evidence that an arrangement exists;(2) delivery has occurred or services rendered; (3) the fee is fixed anddeterminable; (4) collectibility is reasonably assured and (5) the fair valueof undelivered elements, if any, exists. Determination of criterion (4) is based on management’s judgmentregarding the collectibility of invoices for products and services delivered tocustomers.  Should changes in conditionscause management to determine these criteria are not met for certain futuretransactions, revenue recognized for any reporting period could be adverselyaffected.

 

We account for the rebate we granted to Medtronic Xomed in accordancewith EITF 01-9, *Accounting for Consideration Given by aVendor to a Customer (Including a Reseller of the Vendor’s Products)*.  This pronouncement requires that a vendorrecognize rebates as a reduction of revenue based on a systematic and rationalallocation of the cost of honoring rebates earned and claimed to each of theunderlying revenue transactions that result in progress by the customer towardearning the rebate.  Accordingly, as ofSeptember 30, 2004, we recognized an allowance of $39,000 for the estimatedrebate that would accrue to Medtronic Xomed for sales of ENT EndoSheaths thatwere in Medtronic Xomed’s inventory at that date that would be sold to newcustomers under the rebate program. Subsequent to September 30, 2004, we recognize revenue on sales of ENTEndoSheaths to Medtronic Xomed, net of an estimated sales allowance related to thatrebate program.  Measurement of the totalrebate is based on the estimatednumber of customers that will ultimately earn rebates under the offer.  Determination of the number of customers thatwill earn rebates and the amount of those rebates is based on management’sjudgment.  We review our estimates of thenumber of customers that will earn benefits under the rebate program eachfiscal quarter.  If different conditionsresult from those assumptions used in our judgment, the results could bematerially different from our estimates.

 

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*Non-Qualified Options Issued toNon-employees and Employees*

 

We account for non-qualified options issued to non-employees as equityinstruments, in accordance with the provisions of EITF 96-18.  Fair values for these non-qualified optionsare derived from pricing models that consider current market and contractualprices for the underlying financial instruments, as well as time value, yieldcurve and volatility factors underlying the positions.  Pricing models and their underlyingassumptions impact the amount and timing of the value of these non-qualifiedoptions, and the use of different pricing models or assumptions could producedifferent financial results.  We use theBlack-Scholes option-pricing model for determining the value of non-qualifiedoptions issued to non-employees, and we expense that value over the vestingperiod of the non-qualified options.

 

We account for certain non-qualified options granted to employees topurchase our common stock in accordance with APB Opinion No. 25, *Accounting for**Stock Issued to Employees.*  If the fair market value of the underlyingstock at the date of grant is greater than the option price, we recognizecompensation expense for the difference between the market price and the optionprice over the vesting period of the options.

 

*Income Taxes*

 

Under our income tax policy, we record the estimated future tax effectsof temporary differences between the tax bases of assets and liabilities andamounts recorded in the accompanying consolidated balance sheets, as well asoperating loss and tax credit carryforwards. The evaluation of the recoverability of any tax assets recorded on thebalance sheet is subject to significant judgment.  We have provided valuation allowances for allour deferred tax assets to date.

 

**Results of Operations**

 

Net Sales

 

Net sales for the three months ended June 30, 2005 (“Q106”) were $2,532,958, a decrease of $243,822, or 9%, compared to thethree-month period ended June 30, 2004 (“Q1 05”).  During Q1 06, net sales of the medicalsegment decreased by $68,000, or 3%, to $1,909,329, and net sales of theindustrial segment decreased by $175,822, or 22%, to $623,629, compared to Q1 05.  In the medical segment, the net sales and changesin net sales by market were as follows ($000’s):

 
| **Market** | ** ** | **Q1 06** | ** ** | **Q1 05** | ** ** | **Increase  (Decrease)** | ** ** | **Percent** | ** ** |
|------------|------------|-----------|------------|-----------|------------|--------------------------|------------|-------------|------------|
| ENT        |       | $         | 1,249      |      | $          | 1,732                    |       | $           | (483       | ) | (28 | )% |
| Urology    |       | 347       |       | 23        |       | 324                      |       | 1409        | %          |
| Other      |       | 313       |       | 222       |       | 91                       |       | 41          | %          |
| Total      |       | $         | 1,909      |      | $          | 1,977                    |       | $           | (68        | ) | (3 | )% |

 

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*Medical Sales – ENT Market*

 

Net sales to the ENT market include products for domestic andinternational customers as follows:

 
| **ENT Market** | ** ** | **Q1 06** | ** ** | **Q1 05** | ** ** | **Increase (Decrease)** | ** ** | **Percent** | ** ** |
|----------------|------------|-----------|------------|-----------|------------|------------------------------|------------|-------------|------------|
| Domestic       |       | $         | 589        |      | $          | 1,110                        |       | $           | (521       | ) | (47 | )% |
| International  |       | 660       |       | 622       |       | 38                           |       | 6           | %          |
| Total ENT      |       | $         | 1,249      |      | $          | 1,732                        |       | $           | (483       | ) | (28 | )% |

 

We further delineate products sold to the domestic ENT market asfollows:

 
| **ENT Products**      | ** ** | **Q1 06** | ** ** | **Q1 05** | ** ** | **Increase   (Decrease)** | ** ** | **Percent** | ** ** |
|-----------------------|------------|-----------|------------|-----------|------------|---------------------------|------------|-------------|------------|
| Slide-On  EndoSheaths |       | $         | 172        |      | $          | 685                       |       | $           | (513       | ) | (75 | )% |
| Endoscopes            |       | 384       |       | 336       |       | 48                        |       | 14          | %          |
| Other products        |       | 33        |       | 89        |       | (56                       | )          | (63         | )%         |
| Total Domestic  ENT   |       | $         | 589        |      | $          | 1,110                     |       | $           | (521       | ) | (47 | )% |

 

The primary reason for the decrease in salesof products to the domestic ENT market was the build-up of inventory ofSlide-On ENT EndoSheaths at Medtronic Xomed, our exclusive distributor of ENTproducts in the U.S. and Canada.  Thisbuild-up was a result of a difference between the minimum quantities of theSlide-On ENT EndoSheaths that Medtronic Xomed was required to purchase underthe Medtronic Agreement, and their slower than anticipated ramp-up insales.  Total sales to Medtronic Xomed inQ1 06 were $0.649 million, a decrease of approximately $0.502 million, or 44%,compared to $1.150 million in Q1 05. Although Medtronic Xomed did not purchase the required number of ENTEndoSheaths to maintain their exclusivity under the Medtronic Agreement, wehave not exercised our right to terminate their exclusivity, as we believetheir sales of our products will improve, and we currently believe theyrepresent the best alternative for us to distribute our current line of ENTproducts and drive product acceptance of new ENT products in the domesticmarket.

 

During FY 05, we and Medtronic Xomed began arebate program, whereby we offered Medtronic Xomed a cash rebate for thepurchase by new customers of large amounts of ENT EndoSheaths in a one-yearperiod.  The program is designed to rununtil August 31, 2005.  In Q1 06, werecorded sales discounts of approximately $6,000 as a reserve for the rebateprogram, resulting in cumulative reserves of approximately $51,000.  We do not expect significant change in thatsales discount through August 2005, as Medtronic Xomed has indicated the pricereductions under this program were not significant enough to entice customerswho perform large numbers of ENT procedures to purchase EndoSheaths.  The rebates ranged from $.02 to $1.17 perunit, depending upon the price received from the end-user by Medtronic Xomed.

 

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In FY 06, we and Medtronic Xomed plan tointroduce a more attractive pricing program, allowing the price for all newpurchases to decline in steps.  The first150,000 units of ENT EndoSheaths purchased by Medtronic Xomed will be at thecontract price; the next 100,000 will be at the contract price less $1.50 perunit; units over 250,000 will be at the contract price less $2.00 perunit.  The purpose of this price scheduleis to allow Medtronic Xomed to penetrate the market for large institutions andsell ENT EndoSheaths to them at prices those institutions find reasonable.  In addition, we and Medtronic Xomed arehaving discussions to establish additional new programs that will increase thesales of our ENT and TNE products.  We expectto eliminate the rebate program when we finalize the step pricing schedule.  We expect sales of ENT SOS to Medtronic Xomedwill increase each quarter in FY 06 to an annualized rate of 140,000 units bythe quarter ending March 31, 2005.

 

As a result of the Medtronic Agreement, thesuccess of our ENT product lines are substantially dependent upon the successof the marketing and sales activities of Medtronic Xomed over which we havelimited control.

 

Unit sales of ENT EndoSheaths in Q1 06 to thedomestic market were 23,480, a decrease of 70,040, or 75% compared to the 93,520units sold in Q1 05.  The reduction inunit sales was directly related to the inventory build-up at Medtronic Xomedduring the first year of the Medtronic Agreement.  Unit sales of ENT endoscopes in Q1 06 were 65,a decrease of 32, or 33%, compared to the unit sales of 97 in Q1 05.  Sales of ENT EndoSheaths and endoscopesinclude the sales of our ENT-2000 and ENT-1000. The ENT-1000 was released in FY 04. In addition, we sold 21 TNE D endoscopes to Medtronic Xomed, compared to0 in Q1 05.

 

We further delineate products sold to the international ENT market asfollows:

 
| **ENT Products**      | ** ** | **Q1 06** | ** ** | **Q1 05** | ** ** | **Increase  (Decrease)** | ** ** | **Percent** | ** ** |
|-----------------------|------------|-----------|------------|-----------|------------|--------------------------|------------|-------------|------------|
| Slide-On  EndoSheaths |       | $         | 434        |      | $          | 521                      |       | $           | (87        | ) | (17 | )% |
| Endoscopes            |       | 201       |       | 97        |       | 104                      |       | 107         | %          |
| Other products        |       | 25        |       | 4         |       | 21                       |       | 525         | %          |
| Total  International  |       | $         | 660        |      | $          | 622                      |       | $           | 38         |   | 6 | % |

 

The increase in net sales to international distributors is primarilydue to higher unit volume of ENT endoscopes and TNE D endoscopes, offsetpartially by lower sales of ENT SOS.  Unitsales of ENT SOS to the international distributors were 67,880 in Q1 06, a decreaseof 14,920 units, compared to sales in Q1 05. The decrease in sales was due to lower demand, especially in Europe.  We expect unit demand from internationaldistributors to increase overall, due to the planned addition of newdistributors in markets where we do not currently have representation.

 

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Unit sales of ENT endoscopes in Q1 06 to international distributorswere 49, compared to 27 in Q1 05.  Inaddition, we sold 2 TNE D endoscopes to our international distributors inEurope.  We are in the early stages ofselling TNE endoscopes to our distributors, and we plan to increase our salesof this product by increasing the number of distributors in countries where wedo not have representation.  However,there can be no assurance we will be able to consummate these agreements onterms that are beneficial to us. Also, we expect sales of the TNE endoscopeswill improve after we release the new smaller D-shaped fiberscope and newvideoscope in FY 07.

 

Sales of endoscopes are dependent upon a variety of factors, includingthe timing requirements of end users, foreign exchange rates, sales promotionsof international competitors and other factors.

 

*Medical Sales – Urology*

 

The increase in sales of urology products reflects primarily theshipments of our new Flexible Cystoscope (“CST-2000”) with Slide-On EndoSheathSystem to MGU and secondarily to shipments to international distributors.  We sold approximately $320,000 of CST-2000and Slide-On EndoSheaths to MGU in Q1 06, and approximately $28,000 tointernational distributors.  We expectsales of this product line to MGU will be lower in the fiscal quarters endingSeptember 30, 2005 and December 31, 2005 compared to sales in Q1 06.  This reduction is due to the time required totrain MGU sales personnel and to the time needed by the MGU sales representativesto penetrate the urology market.  Weexpect sales in the fiscal quarter ending March 31, 2006 to improve, comparedto the two prior fiscal quarters, reflecting market acceptance of our products.  However, there can be no assurance that thesesales goals will be met.

 

We believe the CST-2000 and EndoSheath System can significantly enhancethe practice efficiency of urologists by allowing them to avoid the tedious andtime-consuming reprocessing of conventional cystoscopes, and presents thesignificant benefit of a sterile insertion tube for each patient.  In addition, the use of our CST-2000 withSlide-On EndoSheath System avoids the need to reprocess endoscopes with harshchemicals, one of which has been contraindicated for use on patients withbladder cancer.

 

*Industrial Segment*

 

The decrease in net sales of the industrial segment was due to higherdemand in the market for video borescopes, compared to our line of fiberborescopes, and lower demand for repairs of fiber borescopes.

 

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Gross Profit

 

Gross profit was $610,140 in Q1 06, a decrease of $472,424, compared togross profit in Q1 05.  Gross profit decreasedby approximately $431,000 in the medical segment, and by approximately $41,000in the industrial segment.  Gross profitin the medical segment decreased due to lower volume of domestic sales of ENTSOS, offset partially by higher volume of domestic TNE D endoscopes, and highervolume of ENT and TNE D endoscopes sold to international distributors.  Gross profit from the sale of urologyproducts remained low due to the initial cost of manufacturingEndoSheaths.  We are in the process of developinga new EndoSheath concept and automated equipment to manufacture our EndoSheathswith channels to lower our manufacturing costs of these products.  We expect this automation equipment to be inplace at the beginning of FY 07.  In theindustrial segment, the decrease in gross profit was due primarily to a decreasein sales volume.

 

Duringthe first fiscal quarter of FY 06, it became apparent that by utilizing asub-contractor in Israel to manufacture our EndoSheaths, we were not able toexert sufficient control over the manufacturing processes to have theconfidence level we believe necessary for our product quality. In addition, werealized that the costs savings we had planned on by manufacturing ourEndoSheaths there were not going to be what we had expected.  Thus, we have decided to move the productionof our EndoSheaths back to our Natick, MA facility, after the details and timeschedules of the transfer have been finalized. To date, we do not believe these assets are impaired based upon theirintended use.  However, depending upondemand for EndoSheaths and upon our ability to reconfigure some of theequipment to manufacture other than ENT EndoSheaths, we may incur a charge forimpairment in the future related to this equipment which is valued atapproximately $350,000 at June 30, 2005.

 

Operating Expenses

 

*Selling, General and Administrative Expenses*

 

The decrease in selling, general and administrative (“SG&A”)expenses in Q1 06 was due primarily to the lower spending for trade shows topromote our urology products, compared to Q1 05.  The costs for promotion of our urologyproducts are now incurred by MGU.

 

*Research and Development Expenses*

 

The increase in research and development (“R&D”) expensesin Q1 06, compared to Q1 05 was due primarily to additional spending for materialsand personnel hired to work on developing new products for the medicalsegment.  We expect R&D expenses willcontinue to be higher in FY 06, compared to FY 05, as we increase our effortsto develop new products for medical markets, both those that will utilize thetechnology inherent in our EndoSheaths, and other products for the medicalmarket.

 

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*Stock-based Compensation Expenses*

 

We incurred stock-based compensation costs during FY 06and FY 05, due primarily 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.  The value ofthe non-qualified options were determined to be approximately $371,000, using theBlack-Scholes option-pricing model, and are being recorded in our statements ofoperations over the vesting period of the options.  We recorded $46,387 of expense in Q1 06 relatedto these non-qualified options.  Inaddition, during the three months ended June 30, 2003, the compensationcommittee of our board of directors authorized the issuance of non-qualifiedoptions to purchase 1,295,000 shares of common stock to certain of ouremployees.  These options were pricedbelow the fair market price of our common stock on the date of grant.  Accordingly, we are recognizing compensationexpense totaling approximately $65,000 from June 2003 through December 2007,the vesting period of these options.  InQ1 06, we incurred $3,297 of expense related to these options in our statementsof operations.

 

Operating Income (Loss)

 

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

 
| **Segment** | ** ** | **Q1 06** | ** ** | **Q1 05** | ** ** | **Change** | ** ** |
|-------------|------------|-----------|------------|-----------|------------|------------|------------|
| Medical     |       | $         | (613       | )         | $          | (20        | )          | $ | (593 | ) |
| Industrial  |       | (14       | )          | 20        |       | (34        | )          |
| Corporate   |       | (255      | )          | (288      | )          | 33         |       |
| Total       |       | $         | (882       | )         | $          | (288       | )          | $ | (594 | ) |

 

In the medical segment, the lower gross profit, and higher spending forR&D resulted in an operating loss for Q1 06.  In the industrial segment, the lower gross profitdue to lower sales volume was the primary cause for the operating loss in Q1 06.  In the corporate segment, the cessation ofspending for support of applications for CMOS patents resulted in a lower loss.

 

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Liquidity and Capital Resources

 

At June 30, 2005, ourprincipal source of liquidity was working capital of approximately $11 million,including $9.0 million in cash and cash equivalents.  At June 30, 2005, we had acceptances payableto a bank totaling approximately $59,000. We have pledged $125,000 to support these acceptances.

 

We also have anagreement with a bank, which includes a revolving line of credit under which wemay borrow up to $1,000,000, net of up to $250,000 of any outstanding lettersof credit and banker’s acceptances. Borrowings under this loan arrangement must be fully cashcollateralized.  The agreement alsostipulates that when we achieve positive cash flow, as defined in the agreement,we will be eligible to negotiate changes to this loan arrangement that mayinclude changing the borrowing base for revolving loans, and the release of thepledged cash collateral.

 

Our cash and cash equivalents decreased byapproximately $903,000 in the three months ended June 30, 2005, due primarilyto cash used for operations of approximately $1,040,000 and cash used forinvesting activities of approximately $110,000. These uses were offset by the exercise of stock options by employees andnon-employees totaling approximately $101,000, and the receipt of asubscription receivable from one of the investors in our sale of common sharesin February 2005 of approximately $92,000. We expect that our current balance of cash and cash equivalents will be sufficientto fund our operations for the next twelve months.

 

We have incurred losses since our inception, and losses are expected tocontinue at least during FY 06.  We havefunded the losses principally with the proceeds from public and private equityfinancings.  The private equityfinancings have included sales of new common stock to two employees who arealso directors, to a hedge fund, to other independent directors and to independentprivate individuals.

 

We expect total spending for property and equipment to be approximately$850,000 for FY 06.

 

We conduct ouroperations in certain leased facilities. These leases expire on various dates through August 31, 2010.  In addition, we have operating leases forcertain office equipment.  These leasesexpire on various dates through June 2007. The following chart summarizes our contractual obligations as of June 30,2005.

 
| **Contractual Obligation** | ** ** | **Total** | ** ** | **Due within 1 year** | ** ** | **Due in 1-3 years** | ** ** |
|----------------------------|------------|-----------|------------|-----------------------|------------|----------------------|------------|
| Operating leases           |       | $         | 1,240,390  |                  | $          | 375,726              |       | $ | 864,664 |   |
| Capital lease              |       | 49,473    |       | 24,913                |       | 24,560               |       |
|                            |            |           |            |                       |            |                      |            |  |  |  |

 

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

 

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## **Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

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

 

#### *Interest and Market Risk*

 

We currently invest our excess cash in a money marketaccount at our bank.  We have not usedderivative financial 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 both fixed-rate and floating-rate interest earning instrumentscarry a degree of interest rate risk. Fixed-rate securities may have their fair market value adverselyimpacted due to a rise in interest rates, while floating-rate securities mayproduce less income than expected if interest rates decline.  Due in part to these factors, our futureinvestment income may fall short of expectations due to changes in interestrates, or we may suffer losses in principal if forced to sell securities whichhave seen a decline in market value due to changes in interest rates.

 

#### *Foreign Currency Exchange*

 

We face exposure, due to purchases of raw materials from Japanesesuppliers, to adverse movements in the value of the Japanese Yen.  This exposure may change over time, and couldhave a materially adverse effect on our financial results.  We may attempt to limit this exposure bypurchasing forward contracts, as required. Most of our Japanese Yen liabilities are settled within 90 days ofreceipt of materials.  At June 30, 2005,our liabilities relating to Japanese Yen were approximately $226,000.

 

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

 

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

 

Based on an evaluation of our disclosure controls and procedures (asdefined in Rules 13a-14(c) and 15d-14(c) under the Securities Exchange Act of1934), the chief executive officer and chief financial officer have concludedthat our disclosure controls and procedures as of the end of the three monthsended June 30, 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 June 30, 2005 that have materially affected, or arereasonable likely to materially affect, our internal controls over financialreporting.

 

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**PART II -OTHER INFORMATION**

 

 

**Item 6. Exhibits**

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

 

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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: August 12, 2005 | /s/  Ron Hadani |   |
|                        | Ron  Hadani |
|                        | President,  CEO (Duly Authorized Officer) |
|                        |   |
|                        |   |
|  Date: August 12, 2005 | /s/  James A. Tracy |   |
|                        | James  A. Tracy |
|                        | Vice  President Finance, Chief Financial Officer and   Controller (Principal Financial Officer and Principal   Accounting  Officer) |
|                             |  |  |  |

 

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